Life 2008 Spring Meeting June 16-18, Session 93, Insurance Taxation in the United States and Canada Similarities and Differences

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1 Life 2008 Spring Meeting June 16-18, 2008 Session 93, Insurance Taxation in the United States and Canada Similarities and Differences Moderator Christian J. DesRochers, FSA, MAAA Authors John T. Adney, J.D. Philip Friedlan

2 Insurance Taxation in the U.S. & Canada: Similarities & Differences Society of Actuaries Life 2008 Spring Meeting Quebec City, Quebec June 18, 2008 Philip Friedlan, BCL, LLB, MBA John T. Adney, JD Christian J. Desrochers, FSA, MAAA, Moderator Agenda Introduction: Scope of Tax Systems & of U.S.-Canada Comparative Discussion Policyholder Taxation: Life Insurance Policyholder Taxation: Annuities Tax Challenges of Policyholder Migration Life Insurance Company Taxation Concluding Thoughts

3 Scope of U.S. & Canadian Tax Systems U.S. - Taxation of worldwide income & estates U.S. citizens Expatriates Non-citizen residents Canada - Taxation of worldwide income of Canadian residents Discussion of nonqualified/non-registered products Life Insurance Tax Treatment by the U.S. - Basic Rules Income tax deferral of policy s inside buildup, subject to IRC Sec Tax-free death benefit Policy not compliant with IRC Sec. 7702: accrual taxation, but tax-free NAR Variable policy can comply Taxation of lifetime distributions depends on modified endowment contract (MEC) status of policy

4 Life Insurance Categorization by Canada Life insurance definition includes Annuity contracts Segregated funds ( Seg funds ) Life insurance Exempt policies Non-exempt policies - Investment Annuities Seg funds - Trust treatment Life Insurance Tax Treatment by Canada Basic Rules Income tax deferral of inside buildup, if exempt policy Tax-free death benefit, if exempt policy Non-exempt policy Accrual taxation On death, mortality gain is tax-free Treatment of lifetime distributions as dispositions

5 Life Insurance Tax Treatment by Canada - Dispositions Dispositions are taxable events Dispositions include surrenders, withdrawals, policy loans, & dividends Collateral assignments for loans excluded Gift is disposition at CSV, taxable benefit? Taxed on excess of proceeds over adjusted cost basis (ACB) ACB = premiums mortality cost No capital gain or loss Life Insurance Tax Treatment by the U.S. - Basic Rules Redux Lifetime distributions may be taxable If MEC: gain-first taxation of withdrawals & surrenders; loans & assignments for loans treated as distributions; 10% penalty tax If non-mec: recover basis first; loans = loans Treatment of gifts: no income tax, but carryover basis & possibly gift tax Basis = premiums untaxed distributions Ordinary income (no capital gain or loss)

6 Life Insurance Tax Treatment - Additional Considerations Policy exchanges tax-free IRS Sec Variable contracts must comply with diversification/investor control rules Change of insured is taxable event Sales of policies: basis & insurable interest issues Treatment of COLI Life Insurance Tax Treatment - Additional Considerations Policy exchanges are dispositions Except ITA Sec. 148(10)(d) Limited rollovers Spouse - inter vivos & death Child, gchild, ggchild - policyholder or transferee Change of insured is taxable event? ITA Sec. 148(10)(d) Sales of contracts disposition treatment Treatment of COLI

7 Comparing Life Insurance Tax Tests So, what is life insurance subject to income tax deferral/exemption? U.S. Life insurance contract & MEC under IRC Sec & 7702A Canada Exempt test policy (ETP) Life Insurance Contract Under Section 7702 Policy must be a life insurance contract under applicable law and must meet either: Cash value accumulation test of Sec. 7702(b) ( CVAT ) or Guideline premium limitation of Sec. 7702(c) & cash value corridor of Sec. 7702(d) ( GPL & CVC Tests ) Includes variable life insurance

8 Choice of Test under Section 7702 CVAT Designed for traditional life Can be used for universal life GPL/CVC Designed for UL Generally cannot change test after issuance Cash Value Accumulation Test (CVAT) Under CVAT, by policy s terms, cash value cannot at any time exceed the net single premium (NSP) for future benefits NSP computed assuming: Greater of 4% interest or policy s guarantees Reasonable mortality: 1980 or 2001 CSO Level death benefit, age maturity, no expenses except for QABs, etc.

9 Guideline Premium Limitation/ Cash Value Corridor Test Guideline premium limitation (GPL): premiums paid cannot at any time exceed greater of: guideline single premium (GSP), or sum of guideline level premiums (GLP) Cash value corridor (CVC) test: death benefit must be at least Sec. 7702(d)-specified percentage of policy s cash value GPL/CVC Test part 2 GSP is computed like NSP but using 6% minimum interest rate & reasonable expenses GLP is level annual equivalent of GSP, using 4% minimum interest rate Adjustment rules & certain exceptions apply GPL & CVC tests must be met in operation

10 MEC Rules of Section 7702A MEC rules deny favorable distribution treatment to investment-oriented policies MEC = policy with premiums paid in violation of 7-pay test limit: Premiums cannot be paid more rapidly than would premiums that pay up a policy in 7 years, disregarding expenses 7-pay test limits generally are calculated using Sec CVAT rules Life Insurance Policy Definition ITA Sec. 248(1), 138(12) Includes annuity contract & Seg fund policy No guidance Apply Provincial law? CRA views

11 Exempt Test Policy Rules Actual policy vs. EPT use of reserve ETP 20-pay endowment at age 85 ETP issued Issue date - AP On PA if DB>108% of DB on prior PA ETP features Anti-dumping/250% rule ETP Rules, part 2 Policy exempt at any time: If policy anniversary Future policy anniversaries Tests satisfied in past AF policy assumptions AF ETP assumptions Interest Mortality

12 Segregated Funds Taxation by Canada Taxed as a trust Non-registered - current taxation of income earned Certain income retains its character in hands of policyholder Dividends, capital gains and losses Interest in Seg fund is capital property Foreign Insurance Entity (FIE) Rules & Life Insurance FIE rules may apply in certain circumstances Ordinary rules not applicable ITA Sec. 148, 12.2, Mark to market treatment - FMV taxation Exceptions

13 Annuity Contract Tax Treatment by Canada Basic Rules, part 1 What is an annuity contract for ITA? Generally, annuity is taxed under life insurance rules, ITA Sec. 148 & 12.2, plus special rules Accrual Annuity Contracts Deferred and pay-out (except prescribed annuity contracts) Annual accrual taxation - AF minus ACB Tax on dispositions Annuity payments not specifically taxed Death benefit payment is a disposition - untaxed accrued income only is taxable Annuity Contract Tax Treatment by Canada Basic Rules, part 2 Prescribed Annuity Contracts Non-registered Conditions - ITA Sec. 304 Regulations Annuity payments commenced Taxation No accrual taxation Level taxation of annuity payments - equal portion is capital & income Dispositions follow usual rule, but no deemed disposition at death

14 Annuity Contract Tax Treatment by the U.S. - Basic Rules, part 1 What is an annuity for IRC purposes? Based on customary practice of insurers Periodic payments (whether or not used) that liquidate principal & earnings Annuity purchase rate guarantees IRC Sec. 72(s) & (u) limits on tax deferral Income tax deferral of inside buildup No deferral for non-u.s.-issued contracts Annuity Contract Tax Treatment by the U.S. - Basic Rules, part 2 Taxation of lump sum distributions: LIFO taxation of withdrawals & surrenders; loans & assignments for loans treated as distributions; 10% penalty tax Taxation of periodic payments: Exclusion ratio applied to payments, equal to basis/expected return Basis = premium(s) paid any untaxed distributions, adjusted for refund feature Special rules for variable payout

15 Annuity Contract Tax Treatment by the U.S. - Basic Rules, part 3 Taxation of death benefit Owner death benefit taxed similarly to surrender, but no penalty tax Annuitant death benefit taxed similarly to surrender Variable annuities included in above, subject to compliance with diversification/investor control rules Migrating Policyholders - Tax Challenges Significant movement of Canadians & Americans across Canada-U.S. border Two countries insurance-related tax rules do not mesh well Demonstrated by preceding discussion Details follow

16 Moving to U.S.: Canadian & U.S. Tax Issues Canadian tax issues triggered by move to U.S.: No deemed disposition of policies Withholding procedures U.S. tax issues triggered by move: Canadian policyholders become U.S. taxpayers U.S. tax definitions apply to Canadianissued policies; no treaty relief Moving to U.S.: U.S. & Canadian Tax Planning New U.S. residents should not hold noncomplying policies Make Canadian polices U.S. compliant or purchase new, U.S.-issued policies (if still insurable) Life insurance product opportunity in dualcompliant policies? No tax-free rollover in Canada Gain triggered on policy transfer

17 Moving to Canada FIE Rules & U.S. Policies U.S. policyholders become Canadian taxpayers Application of FIE rules to U.S.-issued policies Dispose of & re-acquire U.S. policies at FMV Exempt test Applying Canadian rules Moving to Canada: U.S. Tax Issues Nothing new for U.S. citizen/policyholder, except foreign tax credit availability Why? Policyholder didn t leave, according to IRC Policyholder remains concerned with U.S. tax treatment of policy transactions & need for estate planning

18 Migrating Policyholders - Learn More About It See Friedlan-Adney articles: Life Insurance on the Move, Insurance Tax Review (May 2005), pp Life Insurance Across the Border, Report of Proceedings of the Fifty-Seventh Tax Conference, 2005 Conference Report (Toronto: Canadian Tax Foundation, 2006), 9:1-30 Comparing Life Insurance Company Taxation Both Canada & the U.S. impose tax on life insurance company income Purpose of comparison: examine differences in largely similar total income tax regimes Foreign business income of Canadian insurer is not taxed by Canada Also compare premium tax regimes Broad brush approach many details left out

19 Life Insurance Company Taxation by Canada, part 1 Income taxation from Canadian insurance business only Not from foreign insurance business Premium income and investment income Deductions, including reserves Reserves Based on statutory reserves Ppm method Pre-1996 and post-1995 policies Capital taxes Life Insurance Company Taxation by Canada, part 2 Investment income tax 15% tax on inside build-up in exempt policies Proxy for policyholder tax Provincial premium taxes

20 Life Insurance Company Taxation by the U.S., part 1 Federal corporate income tax at 35% rate on annual net earnings of life insurers In general, life insurance company is insurance company with life insurance reserves > 50% of total reserves Life insurance reserves: liabilities for future unaccrued claims for life insurance, annuities, & noncan A&H discounted at interest & recognized mortality/morbidity Life Insurance Company Taxation by the U.S., part 2 For life insurer, taxable income = gross income - deductions Gross income = premiums + investment earnings + any other income/gains Deductions = benefits + increase in reserves (constrained by federally prescribed reserve ) + other deductions Due to reserve deduction, no tax is imposed on inside buildup

21 Life Insurance Company Taxation by the U.S., part 3 Special rules apply to life insurers: Proration severely limited allowance of tax-favored interest & dividends Consolidation with non-life companies 35% & 5-year restrictions Capitalization of deferred acquisition costs (DAC) via proxy rules States apply premium taxes to life insurance & some annuities Separate Account Taxation by the U.S. Separate accounts, or segregated asset accounts, are permitted under state law regulating insurers Assets & liabilities of such accounts often, but not always, are market-valued, whereas most life insurance tax accounting is not For variable life & annuities, IRC Sec. 817 converts market values to book values For modified guaranteed contracts, IRC Sec. 817A uses market values for tax purposes

22 Concluding Thoughts Similarities in compliant life insurance Differences in tax tests for life insurance Are Canadian rules simpler? Significant differences in annuity treatment Life insurance company tax schemes somewhat alike Canadian experience with PBR Tax on investment income Tax challenges of policyholder migration Insurance Taxation in the U.S. & Canada: Similarities & Differences Society of Actuaries Life 2008 Spring Meeting Quebec City, Quebec June 18, 2008 Philip Friedlan, BCL, LLB, MBA John T. Adney, JD Christian J. Desrochers, FSA, MAAA, Moderator

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