In the previous column, we discussed potential problems when a Canadian resident purchases a U.S. life insurance policy. Here, we examine the reverse scenario: life insurance is generally exempt from U.S. taxation, but what happens when a U.S. taxpayer purchases a Canadian life insurance policy that doesn’t meet the complex U.S. tax definition of life insurance?
As U.S. citizens and green card holders are subject to U.S. tax no matter where they reside, any American who buys life insurance in another country could end up with an unexpected U.S. tax liability. A Canadian with a policy from Canada who moves to the U.S. and becomes a U.S. taxpayer may face the same problem.
U.S. exemption test
For U.S. tax purposes, a life insurance policy must qualify under one of two actuarial tests: the cash value accumulation test and the guideline premium test.
In simple terms, the cash value accumulation test limits the policy’s cash value in relation to the death benefit; 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 U.S. tax purposes, a U.S. taxpayer living in Canada could purchase a Canadian life insurance policy that fails to qualify for U.S. tax purposes.
U.S. income taxation of non-exempt policies
When a policy doesn’t meet the U.S. life insurance definition, the income is included as ordinary income for the policy holder.
The amount of income subject annually to U.S. tax on a non-qualifying policy takes into account the policy’s cash surrender and the death benefit amount. As a result, the tax may be incurred on phantom income to which the policy holder 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.
That said, term life insurance policies generally don’t result in U.S. income tax as they don’t accumulate a cash value.
Any U.S. person who intends to purchase a Canadian whole or universal life policy should try to get confirmation from the insurer that the policy qualifies under the U.S. definition. Unfortunately, they would be hard pressed to obtain such a certification.
If that isn’t possible, it may be worthwhile to set up an irrevocable life insurance trust to shelter the policy from U.S. income taxation (to be discussed in a future column).
Fortunately, when the insured person dies, the death benefit generally would not be subject to U.S. tax even though the policy doesn’t qualify.
U.S. insurance excise tax
In addition to the potential income tax complications, the U.S. also imposes an excise tax on premiums paid for foreign life insurance issued to U.S. persons. 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 when a foreign life insurance product qualifies as life insurance for U.S. tax purposes. The tax is payable either by the foreign insurer or by the payer of the insurance premium, and is reported on Form 720.
Responsibility to pay the tax falls first to the person paying the premium, but the insurer is liable if the person doesn’t pay. If neither pays, both can face a penalty. Therefore, the purchaser should confirm with the insurer which party will satisfy the requirement.
Because of the potential tax penalties, U.S. persons would be wise to avoid growth policies when purchasing foreign life insurance and stick to term, unless the insurance company can confirm the policy qualifies under the U.S. definition. They should also remember the 1% tax on the premiums.
The next installment will discuss the use of irrevocable life insurance trusts, which in some cases may solve the U.S. income tax problems with foreign life insurance, though the trusts won’t help with the excise tax.