If you or your client owns a foreign insurance product, the taxation of this policy may fall under different taxation and rules than the policy was designed to follow. At GBL, we are able to analyze and test the policy under the applicable taxation rules to ensure proper tax planning and reporting.
In Canada, life insurance policies must be tested to determine how they’re treated under the Income Tax Act. A policy that passes this “Exempt Test” is considered to be an Exempt Policy and is given preferential tax treatment. A policy that fails the Exempt Test is treated like an investment product, and the yearly growth in its value is taxable as income to the policyholder.
Policies owned by foreign nationals living in Canada are subject to the Canadian Income Tax Act, even if the policy was issued outside of Canada, and therefore are required to be tested under the Exempt Test at each policy anniversary. Unfortunately, most foreign insurers are unable to apply the Exempt Test to their policies, as they are not experts on the Income Tax Act and the Canadian taxation rules. Therefore, a third party, like GBL, must be engaged to run the testing instead.
The U.S. also has their own version of the Exempt Test known as the Section 7702 and 7702A Tests. These tests are used to determine whether a life insurance policy is considered a Life Insurance Contract, a Modified Endowment Contract, or a Failed Contract under the U.S. Internal Revenue Code. Each type of contract is treated differently, with Life Insurance Contracts receiving the most favourable tax treatment and Failed Contracts receiving the least favourable treatment.
Policies held by foreign nationals living in the U.S., as well as by U.S. citizens living outside of the U.S., are all subject to U.S. taxation and should be tested using the Section 7702 and 7702A Tests. Additionally, a portion of the death benefit paid from a Failed Contract may be taxable to the beneficiary, so policies where the beneficiary is a U.S. resident or citizen should also be tested.
The Adjusted Cost Basis (ACB) of a life insurance policy is used to determine the taxable income resulting from the sale or transfer of the policy. It’s also used to determine the taxable income on the growth in value of a non-Exempt Policy.
The ACB is a Canadian concept used solely under the Income Tax Act, and therefore, similar to the Exempt Test, foreign insurers are generally unable to calculate the ACB of their policies. Here at GBL, we can calculate the value of a policy’s ACB when performing an Exempt Test on the policy or if the ACB is required.