17 February 2004 External T.I. 2003-0039821E5 - Taxation of annuity received from Netherlands

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: Is taxpayer taxable on interest and capital amounts? Is interest on loan to purchase annuity deductible? Are annuity payments eligible for pension amount credit? Does the amount on deposit in the Netherlands "foreign property" for foreign property reporting?

Position: No, only interest. Yes, unless it is a prescribed annuity. Yes. This will be foreign property for 2003 years and following..

XXXXXXXXXX 	2003-003982
		Eliza Erskine
February 17, 2004

Dear XXXXXXXXXX:

Re: Taxation of Dutch Annuity (the "Annuity") After Immigration to Canada

This is in reply to your letter of September 15, 2003, regarding the taxation of an annuity acquired by your client in the Netherlands prior to immigrating to Canada. We also acknowledge your telephone message to us of January 30, 2004 (XXXXXXXXXX/Erskine) confirming that the Annuity was purchased while the taxpayer was resident in the Netherlands. We note that this fact does not materially affect our comments, except that some of our comments are only relevant if the taxpayer owned the Annuity prior to immigrating to Canada.

Facts

The taxpayer (your client) is a Canadian resident who moved to Canada from the Netherlands in XXXXXXXXXX. Prior to immigrating to Canada, the taxpayer sold a XXXXXXXXXX business. We understand from your letter that the taxpayer was able to defer the Dutch tax on the capital gains arising from the sale by investing an equal amount in the Annuity, that is, the taxpayer was able to deduct the principal of the Annuity from income, thereby offsetting the capital gains. The Annuity operates so as to pay back the taxpayer's principal (with interest) over a 20-year period. The Annuity ends if both the taxpayer and his wife die before the end of the 20-year period. Dutch tax is withheld on the annuity payments in the Netherlands at a rate of 15%, which we assume is in accordance with the

Canada-Netherlands Income Tax Convention (the "Treaty").¹ You note that the Annuity was not subject to deemed pay-out and taxation rules upon the taxpayer's emigration from the Netherlands.

Issues

1. Is the taxpayer taxable in Canada on the full amount of the payments (i.e., both principal and interest) or only on the interest portion of the payments?

2. If the taxpayer borrowed funds in order to purchase the Annuity, is the interest on the borrowed money a deductible interest expense?

3. Is the taxable portion of the payments (see issue #1) eligible for treatment as pension income for purposes of the pension credit?

4. Is the amount on deposit in the Netherlands "foreign property" for purposes of the foreign property reporting rules in the Income Tax Act and Regulations (the "Act" and "Regulations" respectively)?

Our Comments

The circumstances outlined in your letter relate to a specific situation involving a particular taxpayer. We note that written confirmation of the tax implications arising out of a particular fact situation are given by this Directorate only where the circumstances or events are the subject matter of an advance income tax ruling request. Please see the current version of Information Circular IC 70-6, Advance Income Tax Rulings, which can be found on the Canada Customs and Revenue Agency (the "CCRA") website at www.ccra-adrc.gc.ca, for information regarding the scope of the services provided by this Directorate and how to obtain an advance income tax ruling. There is a fee for obtaining an advance income tax ruling. Our Directorate also provides non-binding technical interpretations at no charge with respect to hypothetical scenarios. We do not provide information in the nature of a tax consultation or tax advice, however. As a result, we cannot give you a detailed response to your questions. We can offer the following general comments, however, which may be helpful to you.

Issue 1: Are both principal and interest amounts taxed in Canada?

As you may be aware, individuals immigrating to Canada are subject to paragraph 128.1(1)(b) 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 from the deemed disposition. However, based on the information provided, it appears that the Annuity is an "excluded right or interest" as defined in subsection 128.1(10) of the Act, which means that 128.1(1)(b) did not apply to the Annuity when the taxpayer immigrated to Canada. 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".

Annuity income is generally included in income for Canadian tax purposes under either section 12.2 of the Act or paragraph 56(1)(d) of the Act. Section 12.2 applies to an interest in a life insurance policy, last acquired after 1989, other than an interest in a policy that is an exempt policy, or a prescribed annuity contract. There is a third exception of very limited application in paragraph 12.2(1)(c) of the Act that is not discussed in this interpretation letter but that you may wish to review. The Annuity appears to be a life insurance policy within the meaning of subsection 138(12) of the Act (which is the meaning of that term for purposes of the Act, pursuant to subsection 248(1)), as the definition of "life insurance policy" in subsection 138(12) includes "an annuity contract". Consequently, it is likely that section 12.2 applies to the Annuity, subject to the exceptions mentioned above. This is a question of fact and law, however, that must be determined taking into account the terms of the annuity contract and any relevant circumstances.

Pursuant to subsection 12.2(1) of the Act, the income inclusion for a particular taxation year under a non-exempt life insurance policy last acquired after 1989 is generally based on the excess of the policy's "accumulating fund" (as defined in section 307 of the Regulations) each year, over its "adjusted cost basis", as defined in subsection 148(9) of the Act. The accumulating fund is essentially a measure of the accumulating investment growth or build-up over time. The adjusted cost basis is essentially the cost of the policy adjusted for certain items such as premiums paid under the policy and any amount of income previously included in computing the policyholder's income. As discussed in Interpretation Bulletin IT-87R2, Policyholders' Income from Life Insurance Policies, which can be obtained from our website at www.ccra-adrc.gc.ca under income tax technical publications, the determination of the accumulating fund and the adjusted cost basis of a policy generally requires information that is available only in the accounts of the issuer of the policy.

The definitions of "exempt policy" and "prescribed annuity contract" are found in Regulations 306 and 304 respectively. It is unlikely that the Annuity is an exempt policy, as the definition of that term excludes annuity contracts. A discussion of the meaning of "prescribed annuity contract" is beyond the scope of this interpretation letter. Regulation 304 is a highly detailed provision that can only be applied with a full knowledge of all of the facts and circumstances of the situation. If section 12.2 does apply to the Annuity, we

note that the computation in subsection 12.2(2) for amounts to be included in income with respect to the Annuity effectively results in only interest (i.e., amounts other than principal) being included in the taxpayer's income for purposes of the Act.

Generally, if section 12.2 of the Act does not apply to the Annuity, then paragraph 56(1)(d) of the Act will apply to the Annuity. Paragraph 56(1)(d) includes in income "any amount received by the taxpayer in the year as an annuity payment other than an amount ... with respect to an interest in an annuity contract to which subsection 12.2(1) applies..." Paragraph 56(1)(d) includes the whole amount of the annuity payments in income (i.e., principal as well as interest), however, paragraph 60(a) of the Act provides a deduction from income for the taxation year of "the capital element of each annuity payment included by virtue of paragraph 56(1)(d)", which is defined to be "if the annuity was paid under a contract, an amount equal to that part of the payment determined in prescribed manner to have been a return of capital...".

We note that the proposed foreign investment entity ("FIE") rules found in sections 94.1 and 94.2 of the Act may apply to the taxpayer's interest in the Annuity, as interests in foreign insurance policies (which would include the Annuity) are deemed to be participating interests to which the FIE rules apply (see in particular proposed subsections 94.2(10) and (11) of the Act). There is a general exemption from the application of these rules for individuals who have been resident in Canada for a total of 60 months or less (the "exempt taxpayer" exception). There is also an exemption from the FIE rules for an interest in a foreign insurance policy where the Minister of National Revenue is satisfied that the taxpayer has included in income the amount required under section 12.2 of the Act for the taxation year in respect of the interest. Finally, there is a specific exemption for individuals under the FIE rules for an interest in a foreign insurance policy where the policy was acquired more than 60 months before the taxpayer became resident in Canada, subject to certain restrictions that likely do not apply in the present situation. The application of these rules and the exemptions from these rules are beyond the scope of this interpretation letter, and we suggest that you contact a tax professional who is familiar with the operation of these rules if you require specific advice regarding how these rules could apply to the taxpayer now or in the future.

Issue 2: Interest Deductibility

Under subparagraph 20(1)(c)(i) of the Act, interest on borrowed money used to acquire a life insurance policy, the definition of which includes an annuity contract, is specifically disallowed unless it falls within the ambit of subparagraph 20(1)(c)(iv) of the Act. Subparagraph 20(1)(c)(iv) of the Act is applicable in respect of annuity contracts which are subject to the accrual rules contained in section 12.2 of the Act. However, as noted above, section 12.2 of the Act excludes a prescribed annuity. Consequently, interest on borrowed money used to acquire a prescribed annuity contract would not be deductible from income. It does not appear that the Annuity is a prescribed annuity, however, we reiterate that this is a question of fact.

Issue 3: Pension Credit

Subsection 118(3) of the Act allows a taxpayer to claim a pension credit in respect of certain pension income received in the year to a maximum of $1,000 or the amount received (whichever is less). Where the taxpayer has not attained age 65 by the end of the calendar year, the pension credit may only be claimed if the pension income received is "qualified pension income", as defined in subsection 118(7) of the Act. It does not appear that payments under the Annuity would be "qualified pension income". Where the taxpayer has attained age 65 by the end of the calendar year, the pension credit may be claimed with respect to "pension income" as defined in subsection 118(7). Paragraph (b) of this definition includes "the total of all amounts each of which is an amount included in computing the individual's income for the year by reason of section 12.2 of [the] Act or paragraph 56(1)(d.1) of the [1952 Income Tax Act]". Thus, payments under the Annuity may be "pension income" that qualifies for the pension credit if the taxpayer has attained age 65 by the end of the calendar year. Please see the current version of Interpretation Bulletin IT-517, Pension Tax Credit, for a more detailed review of the pension credit provisions of the Act. See also the Canada Customs and Revenue Agency's publication T4084, Pension Adjustment Calculation Guide.

4. Foreign Property Reporting Rules

The foreign property reporting rules can be found in section 233.3 of the Act. Subsection 233.3(3) requires a "reporting entity" to file a return in prescribed form (T1135) by that person's normal tax return filing deadline under Part I of the Act. Subsection 233.3(1) defines a "reporting entity" to be a "specified Canadian entity" whose total cost amount of "specified foreign property" exceeds $100,000. The term "specified Canadian entity" is defined by exclusion, however, an individual who is resident in Canada will generally be a "specified Canadian entity". A "specified foreign property" is defined in subsection 233.3(1) of the Act. Proposed paragraph 233.3(1)(d.1) of the Act, which if enacted will be applicable to returns for taxation years that begin after 2002, includes in the definition of "specified foreign property", "an interest in an insurance policy that is deemed by subsection 94.2(11) to be a participating interest in a non-resident entity". As discussed above, the Annuity may be such an interest.

We hope that our comments will be of assistance. Again, we would advise you or your client to discuss this matter with a Canadian tax advisor specializing in the taxation of foreign annuities or life insurance products if you require specific advice or information relating to your client's particular fact situation.

Yours truly,

Jim Wilson
for Director
International and Trusts Division
Income Tax Rulings Directorate

ENDNOTES

1 This rate appears to be correct as the payments, based on the given facts, are annuities that are periodic payments arising in the Netherlands for purposes of Article 18(2) of the Treaty.