18 February 1999 External T.I. 9817165 - SEGREGATED FUND-FORM OF GUARANTEE

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

The income tax treatment to the insurer and to the policyholder of a form of guarantee which is provided by the insurer with respect to a segregated fund policy.

Position:

1. The provisions of section 138.1 will apply to the policyholder regardless of the fact that the "guarantee" payment is paid to the policyholder via the segregated fund trust or paid directly to a beneficiary of the policyholder.

2. The insurer would not be entitled to claim a deduction where it transfers funds with respect to the "guarantee" into the segregated fund trust.

3. Where the insurer pays the "guarantee" directly to the policyholder or to a beneficiary of the policyholder then we are of the view that the insurer would be entitled to claiming a deduction for income tax purposes with respect to the "guarantee" payment.

Reasons:

1. The provisions of paragraph 138.1(1)(j) provide for this treatment to the policyholder.

2. The provisions of the Act do not provide any basis for a deduction to the insurer in respect of the assets transferred to the segregated fund trust.

3. Where the insurer makes the "guarantee" payment directly then section 9 of the Act should apply.

XXXXXXXXXX 								981716
									Michèle Trotier
Attention:  XXXXXXXXXX 

February 18, 1999

Dear Sirs:

Re: Segregated Funds

This letter is a follow-up to our letter of June 30, 1998 wherein we indicated that we would provide you with a general opinion addressing certain interpretational issues dealing with the application of section 138.1 of the Income Tax Act (the "Act") which were identified in your March 18, 1998 request for an advance income tax ruling which was later withdrawn.

The hypothetical situation which we will be discussing in our letter relates to an annuity contract that is a segregated fund policy (the "Policy") as described in section 138.1 of the Act to be issued by a life insurance company (the "Insurer") to an individual policyholder (the "Policyholder"). The Policyholder's premium would be deposited into a segregated fund (the "Fund") in respect of which the Policyholder would be notionally allocated units of the Fund. The Policyholder is deemed pursuant to paragraph 138.1(1)(e) of the Act to have an interest in the related segregated fund trust. The Insurer would provide a form of guarantee (the "Maturity Guarantee") with respect to the Policy at each successive 10th anniversary date (the "Maturity Date") of the initial purchase date of the Policy such that the Policyholder will be guaranteed to receive an amount not less than the premium paid to acquire the Policy assuming no withdrawals in the intervening period.

If on the Maturity Date the fair market value of the notional units of the Fund allocated to the Policyholder is less than the premium paid to acquire the Policy the Insurer would transfer additional assets from its general funds to the Fund and additional notional units would be allocated to the Policyholder. As a consequence while the Policyholder would have more notional units in the Fund, the fair market value of all notional units would, at that time, equal the premium paid to acquire the Policy.

The Insurer would also provide a form of guarantee under the Policy (the "Death Guarantee") such that on the death of the annuitant the beneficiary will be entitled to receive an amount not less than the premium paid to acquire the Policy assuming no withdrawals in the intervening period.

Our comments are based on the premise that the Maturity and the Death Guarantees form part of the Policy and as such are subject to the provisions of section 138.1 of the Act.

We are generally of the view that guarantee payments under the Maturity and the Death Guarantees would be taxable to the Policyholder when the Fund is distributed to the Policyholder and this even though, as described above, the Death Guarantee may be payable directly to the beneficiary.

The Maturity Guarantee provides that the Insurer will transfer assets from its general funds into the Fund. We note that there would be a disposition of these assets by the Insurer for purposes of Part 1 of the Act. We are of the view that paragraph 138.1(1)(d) of the Act would apply such that the Insurer would be deemed to have an interest in the related segregated fund trust on the basis that the funds transferred by the Insurer from its general funds into the Fund were not funded with premiums paid under the Policy. We are also of the view that the amount of these additional assets to be transferred by the Insurer into the Fund would not be deemed to be proceeds from the disposition of an interest by the Policyholder in the related segregated fund trust pursuant to paragraph 138.1(1)(j) of the Act until such time as the Policyholder receives or becomes entitled to receive in the year such an amount.

We note that the determination of which person would be entitled to the income generated from the additional assets the Insurer has transferred from its general funds into the Fund with respect to the Maturity Guarantee remains a question of fact. It appears that following the application of paragraph 138.1(1)(d) of the Act such income should normally be allocated to the Insurer rather than the Policyholder although the terms and conditions of the Policy would have to be taken into account before a determination in this regard can be made.

Assuming the Policyholder does not become entitled to the payment of funds represented by the additional assets until the Policy is surrendered, at the time the payment is made it will constitute proceeds of disposition of an interest of the Policyholder in the segregated fund trust. It appears the Insurer will also dispose of its interest in the segregated fund trust at this time for nil proceeds which would result in a capital loss to the Insurer. At this point it does not appear to us that there is any basis under the provisions of the Act for the Insurer to claim a full deduction in respect of the assets transferred to a segregated fund trust in respect of a Maturity Guarantee.

The following example illustrates what we consider to be the tax consequences to the Policyholder described above. Policyholder pays a premium of $1,000 which is deposited in the Fund. The $1,000 is used to acquire shares at a cost of $1,000. The Policyholder is allocated 100 notional units in the Fund. The Policyholder is the only one participating in the Fund. At the Maturity Date the fair market value of the notional units in the Fund is $800. The Insurer contributes an additional $200 of assets to the Fund, cash in our example. We are assuming that under the terms and conditions of the Policy the Policyholder would be allocated an additional 25 notional units in this case (25 @ $8/unit= $200). The Policyholder would then have 125 notional units in the Fund and the total fair market value of all the 125 units would be $1,000. The Policyholder then terminates the Policy. The shares in the Fund are sold for their fair market value, $800, resulting in a capital loss of $200. Pursuant to the provisions in subsection 138.1(3) of the Act this capital loss would be allocated to the Policyholder. The adjusted cost base of the Policyholder's interest of the segregated fund trust would be reduced pursuant to paragraph 53(2)(q) of the Act. As a result, the Policyholder would incur a capital gain of $200 on the surrender of the Policy which would be the difference between the $1,000 which the Insurer would distribute to the Policyholder and the $800 being the amount of the adjusted cost base of the interest in the segregated fund trust. This $200 capital gain would be allocated to the Policyholder pursuant to subsection 138.1(3) of the Act and would offset the above $200 capital loss previously allocated to the Policyholder.

If rather than transferring assets to the Fund in respect of the Maturity Guarantee the Insurer pays the amount directly to the Policyholder it is our view that such payment would be treated as proceeds to the Policyholder in respect of the disposition of an interest in the segregated fund trust pursuant to paragraph 138.1(1)(j) of the Act. In this case the Insurer should be entitled to deduct the payment in computing its income pursuant to section 9 of the Act. Assuming the Policyholder terminated the Policy immediately after receipt of the guarantee payment he/she would be in the same tax position as described above - a $200 capital gain and a $200 capital loss. We have advised the Department of Finance of the discrepancy in the income tax treatment to the Insurer of the Maturity Guarantee payment, as described above, for their consideration.

We are of the view that the Death Guarantee, as indicated above, forms part of the Policy and as such is a benefit that the Policyholder becomes entitled to receive to which paragraph 138.1(1)(j) of the Act would apply. One would have to consider the terms and conditions of the Policy to determine when an amount would be payable to the Policyholder with respect to the Death Guarantee but generally we would expect that this would occur immediately after the death of the Policyholder.

The foregoing comments are intended as a general discussion only and do not relate to any particular situation. While we hope our comments are of assistance to you they neither address all of the potential income tax implications nor do they constitute an advance income tax ruling and therefore are not binding on the Department in respect of a specific situation.

Yours truly,

F. Lee Workman
Section Manager
Financial Institutions Section
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate