18 August 2010 External T.I. 2010-0371161E5 - US Annuities

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: (1) Is a US annuity an exempt policy? (2) Is an annual accrual of income required? (3) Is a withdrawal subject to tax in Canada? (4)Is there double taxation resulting from a potential annual accrual and a subsequent withdrawal from the annuity? (5) What exchange rates should be used in the calculations? (6) Can a capital gain be claimed on the foreign exchange fluctuations? (7) Can any taxable amounts be split with a spouse?

Position: (1) Question of fact (2) Yes (3) Yes (4) No (5) Exchange rate in effect at time of transaction (6) No (7) Maybe

Reasons: (1) It is a question of fact but likely not exempt under Regulation 306. (2) Subsection 12.2(1) requires an inclusion of accrued income on an annual basis on each anniversary day of the policy. (3) Subsection 148(1) requires a taxpayer to include in income a gain on (partial) surrender of an interest in a life insurance policy. (4) Double taxation does not occur on a surrender of a life insurance policy as the annual accrual included in income is added to the adjusted cost basis. (5) Based on Canadian jurisprudence, exchange rates should be used at the relevant time of the transaction. (6) Foreign exchange gains are fully taxed as income inclusions with the annual accrual inclusion. (7) Pursuant to section 60.03 and subsection 118(7) of the Act, a taxpayer may be able to split the annuity accrual with a spouse or common-law partner if it meets the definition of "eligible pension income".

XXXXXXXXXX
2010-037116 P. Waugh
August 18, 2010

Dear XXXXXXXXXX :

Re: United States Annuity Contract

I am writing in response to your letter of June 4, 2010 concerning the taxation of a United States ("US") Individual Flexible Premium Variable Annuity (the "Annuity").

In the situation you described, you and your wife are the owners of the Annuity purchased XXXXXXXXXX , 2000 with an initial premium payment of $XXXXXXXXXX . No further premium payments have been made and the Annuity commencement date is XXXXXXXXXX , 2020. You moved to Canada at the end of 2008 and the current value of the Annuity is less than $100,000.

Our Comments

Written confirmation of the tax implications inherent in particular transactions may only be provided by this Directorate where the transactions are proposed and are the subject matter of an advance income tax ruling submitted in the manner set out in Information Circular 70-6R5, Advance Income Tax Rulings, dated May 17, 2002. This Information Circular and other Canada Revenue Agency ("CRA") publications can be accessed on the Internet at http://www.cra-arc.gc.ca. Where the particular transactions are completed, the inquiry should be addressed to the relevant Tax Services Office ("TSO") with a complete description of all the relevant facts and include all documentation that will assist that TSO in their review. We are, however, prepared to provide the following general comments.

Subsections 138(12) and 248(1) of the Act define a "life insurance policy" to include an annuity contract. Therefore, unless otherwise stated, whenever the Act uses the term "life insurance policy", it also refers to an annuity contract. It is also to be noted that the residence of the insurer is not relevant in determining whether an insurance policy constitutes a life insurance policy within the meaning of subsection 138(12) of the Act. Thus, an insurance policy issued by a non-resident insurer can constitute a life insurance policy for the purposes of the Act.

Annual Income Inclusion

In accordance with subsection 12.2(1) of the Act, where a Canadian resident taxpayer holds an interest a "life insurance policy", the taxpayer will be required to accrue income on such a policy on an annual basis for each year that he holds an interest in the policy and amounts actually received under the policy will then not be subject to tax. If the annuity contract is an "exempt policy" or a "prescribed annuity contract" ("PAC"), annual accrual taxation will not apply, and as amounts are actually received under the contract, they will then be subject to tax under paragraph 56(1)(d) of the Act (a deduction for the capital element of such amount is allowed under paragraph 60(a) of the Act.).

Subsection 12.2(11) of the Act defines the term "exempt policy" to have the meaning prescribed by the Income Tax Regulations ("Regulations"). In accordance with the definition in Regulation 306, an exempt policy specifically excludes an annuity contract.

Therefore, it would appear based on the information provided that the Annuity is not an exempt policy, as the definition of that term excludes annuity contracts, and the remainder of our comments will focus on the tax implications for an annuity.

Where an interest in a life insurance policy is not a PAC or exempt policy, in accordance with subsection 12.2(1) of the Act, the annual accrual to be included in income is the amount by which the accumulating fund (as defined in section 307 of the Regulations) exceeds the adjusted cost basis ("ACB" as defined in subsection 148(9) of the Act) for each interest in a life insurance policy calculated on the anniversary day of the contract.

In general terms, the accumulating fund of a life insurance policy is a measure of the accumulated savings that have built up within the policy. The ACB is essentially the cost of the interest in the policy adjusted for certain items. One adjustment is that any accrual amount included in income in a year is added to the ACB. These amounts are generally computed by the life insurance company when the insurer is a resident of Canada, but they may not be available from foreign insurers. Further information regarding the calculation of the accumulating fund of a life insurance policy and the ACB to a policyholder of an interest in a life insurance policy can be found in Interpretation Bulletin IT-87R2, Policyholders- Income from Life Insurance Policies.

Disposition

A "disposition" of an interest in a life insurance policy is defined in subsection 148(9) of the Act to include "a surrender thereof" (including a partial surrender) and includes a withdrawal from an annuity. Under subsection 148(1) of the Act, a taxpayer is required to include in computing income in respect of the disposition of an interest in a life insurance policy the amount by which the proceeds of disposition of the interest in the policy exceeds the ACB of that interest immediately before the disposition. Since accrued amounts previously included in income form part of the ACB, double taxation would not arise if the original premium is withdrawn or an annuity is cancelled.

Any such gain resulting from the disposition, except to the extent an interest in the life insurance policy is deemed to be an interest in a related segregated fund trust, is precluded from capital gains treatment by virtue of subparagraph 39(1)(a)(iii) of the Act. Instead, the full amount of the gain is required to be included in the policyholder's income by virtue of paragraph 56(1)(j) of the Act. When a policy acquired after December 1, 1982 is partially surrendered, the ACB of the policy is usually prorated under subsection 148(4) of the Act.

Where more than one taxpayer holds an interest in the same annuity, both are required to include in income their proportionate share of the annual accrual or gain resulting from a withdrawal or cancellation. Your proportionate share will be equal to the interest you hold in the Annuity.

Pension Income Splitting

The annual accrual required to be included in income may be eligible for pension income splitting. The 2007 Federal Budget provided new rules for pension income splitting with the addition of section 60.03 of the Act, effective for 2007 and later taxation years. Pursuant to section 60.03 of the Act, a taxpayer is permitted to split eligible pension income with his or her spouse or common-law partner if the taxpayer received "eligible pension income". For the purposes of section 60.03 of the Act "eligible pension income" has the meaning assigned in subsection 118(7) of the Act, and is generally defined as "pension income" received in a taxation year by an individual who is 65 years of age or older, and where an individual is under 65 years of age, the "qualified pension income" received in a taxation year. The term "pension income" is defined by subsection 118(7) of the Act and includes all amounts included in an individual's income in respect of insurance policies or annuity contracts under section 12.2 of the Act.

Immigration to Canada

Individuals immigrating to Canada are subject to paragraphs 128.1(1)(b) and (c) of the Act which provides that, for purposes of the Act, an individual is deemed to dispose of all of the individual's property (with certain exceptions), for fair market value prior to entering Canada. The property subject to the deemed disposition is then deemed to be reacquired by the individual for a cost equal to the proceeds of disposition. Very generally, the effect of this is that, for purposes of computing Canadian tax, an individual who becomes resident in Canada will have a cost base for most of his or her property that is equal to the fair market value of the property upon entering Canada. Property is defined in subsection 248(1) of the Act and would normally include an interest in a deferred annuity contract. However, the deemed disposition in paragraph 128.1(b) of the Act does not apply to certain specified exceptions. One such exception is for property that is an "excluded right or interest" which is defined in subsection 128.1(10) of the Act. Paragraph (f) of the definition of "excluded right or interest" refers to "a right of the individual to receive a payment under (i) an annuity contract, or (ii) an income-averaging annuity contract."

Foreign Currency

Any amounts received in a foreign currency which are taxable in Canada should be converted to Canadian currency using the exchange rate in effect at the time of the transaction. Any annual accrual required to be included in income or any gain resulting from a withdrawal should be calculated based on the exchange rate in effect at the relevant time of each component (date of withdrawal to calculate proceeds of disposition; each anniversary date of the accrual to factor into the ACB; date of the purchase for ACB calculation, etc.).

Income Tax Convention

Under Article XVIII of the Canada-United States Tax Convention (1980) (the "Treaty"), both Canada and the US may tax pensions and annuities. However, Canada may only tax pensions and annuities arising in the US to the extent that the pension/annuity would have been included in US income if the recipient were a US resident. For the purposes of the Treaty, the term "annuity" means "a stated sum paid periodically at stated times during life or during a specified number of years, under an obligation to make the payments in return for adequate and full consideration (other than services rendered), but does not include a payment that is not a periodic payment or any annuity the cost of which was deductible for the purposes of taxation in the Contracting State in which it was acquired." While it remains a question of fact as to whether a particular deferred annuity would be considered an annuity or a pension for the purpose of the Treaty, the Treaty does not automatically supersede the application of section 12.2 of the Act to a deferred annuity.

If the Annuity is not subject to accrual taxation in the US, there remains a possibility for non-symmetrical taxation for which no relief exists under the current Treaty. If this happens, Paragraph 7 of Article XVIII of the Treaty may apply to provide relief where one country requires current recognition of income for tax purposes but the other country defers taxation until such income is received. For this paragraph of the Treaty to apply, the individual must be "...a citizen or resident of a Contracting State and a beneficiary of a trust, company, organization or other arrangement that is a resident of the other Contracting State, generally exempt from income taxation in that other State and operated exclusively to provide pension, retirement or employee benefits...". This rule provides a mechanism whereby an individual, assuming the above criteria are met, may be allowed to elect to defer taxation under rules established by the competent authority of that State with respect to income accrued but not distributed under that plan or any plan substituted for such a plan. If it is determined that non-symmetrical taxation exists and the criterion outlined in Paragraph 7 of Article XVIII of the Treaty is met, you can make a request to the competent authority of Canada. For more details, refer to Information Circular IC71-17, Guidance on Competent Authority Assistance Under Canada's Tax Conventions.

Foreign Tax Credit

Where foreign taxes are withheld or paid on an annuity payment (including a withdrawal), for Canadian income tax purposes, the taxes are considered to be non-business taxes paid to the foreign country. Consequently, an individual may be entitled to claim a foreign tax credit with respect to the foreign taxes withheld or paid. In basic terms, the foreign tax credit is computed as the lesser of the foreign taxes paid and an amount that is approximately equal to the taxes the resident of Canada would otherwise pay in respect of the payment. For additional details on the foreign tax credit rules, please refer to Interpretation Bulletin IT-270R3, Foreign Tax Credit or contact our International Tax Services Office (ITSO) which handles questions regarding the application of our foreign tax credit rules. The ITSO can be reached at 1-800-267-5177 and answers questions as to whether a particular tax qualifies for the foreign tax credit or how to compute the foreign tax credit.

Foreign Property Reporting

The foreign property reporting rules set out in section 233.3 of the Act require a person that owns "specified foreign property", the total cost of which exceeds $100,000 at any time in the year, to file a prescribed form (T1135) by that person's normal tax return filing deadline under Part I of the Act. A "specified foreign property" is defined in subsection 233.3(1) of the Act and could include, where applicable, a taxpayer's interest in a foreign life insurance policy. The $100,000 test for the purposes of section 233.3 of the Act is applied to the "cost amount" of all "specified foreign property" of the taxpayer, computed in the aggregate. Accordingly, where the aggregate of the "cost amount" of all the "specified foreign property" held by a taxpayer exceeds $100,000, the taxpayer will be required to report each "specified foreign property" held by the taxpayer, even though no particular "specified foreign property" has a "cost amount" exceeding $100,000. Subsection 248(1) of the Act defines the phrase "cost amount" for purposes of the Act.

Amendments to Previous Tax Returns

If it is determined that an annual accrual of income required under subsection 12.2(1) of the Act was not included in a previously filed tax return and should have been, amendments will need to be made to the previously filed tax return. When a taxpayer notifies CRA that a previous return needs to be amended to include additional income, the taxpayer will be assessed interest on any outstanding balance owing to CRA. While amendments to previously filed returns can be made on form T1 Adjustment Request, in order to avoid any possible penalties, the best way to notify CRA of the additional income is through a voluntary disclosure.

CRA's Voluntary Disclosures Program ("VDP") is designed to encourage taxpayers to come forward and correct inaccurate or incomplete information or to disclose information that has not been reported during previous dealings with the CRA, without penalty or prosecution. However, it should be noted that relief from penalties would only be granted to any taxation year that ended within the previous 10 years before the calendar year in which the voluntary disclosure submission is filed and where full disclosure is made. If a taxpayer wants to make a voluntary disclosure, he/she should complete form RC-199, Voluntary Disclosures Program (VDP) Taxpayer Agreement and attach it to the disclosure submission with any supporting documentation. It is important for a taxpayer to indicate clearly, on any disclosure made, that he/she is submitting information under the VDP.

A taxpayer can complete and submit the RC-199 form or have an authorized representative do so on his/her behalf. A submission must be in writing and mailed or faxed to the TSO that has jurisdiction over the area where the taxpayer resides. For more details, and to see if a disclosure qualifies for this program, see Information Circular IC00-1R2, Voluntary Disclosures Program or call 604-587-2022 or 1-800-959-8281.

The taxation and characterization of foreign-based annuity payments are complex issues and the full terms and conditions of a particular annuity contract must be examined in detail before a determination can be made with respect to the tax treatment of any payments received. For this reason, we would advise you to discuss this matter with a Canadian tax advisor specializing in the taxation of foreign annuities or life insurance products if you require more specific advice or information relating to your particular fact situation.

We hope that our comments will be of assistance.

Yours truly,

Randy Hewlett
Manager
for Director
Ontario Corporate Tax Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch