25 February 1998 External T.I. 9731265 - US TAX DEFERRED 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.

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:

Whether the deemed accrual rules under section 12.2 of the Act can apply to a US tax deferred annuity? If the deemed accrual rules apply and the foeign tax credits are unable to be fully utilized due to the mismatching of income and income taxes between the Canada and the US is there any relief under the Canada-US Income Tax Convention?

Position:

The treatment of a particular foreign based tax deferred product is a question of fact but section 12.2 does in fact apply to a foreign annuity. It is also possible that there is no relief under the Canada-US Income Tax Convention but this too will ultimately depend on whether the tax deferred product is considered to be a pension, employment benefit or some other form of retirement plan.

Reasons:

See above

973126
XXXXXXXXXX M. Cooke

Attention: XXXXXXXXXX

February 25, 1998

Dear Sirs:

Re: US Tax Deferred Annuities

This is in reply to your facsimile of July 24, 1997 which has been transferred to our Directorate from Revenue Canada's International Tax Services Office on November 26, 1997. You are inquiring about the income tax implications under the Canadian Income Tax Act (the "Act") where an individual owns a deferred annuity contract that was issued by a foreign insurance corporation in the following situation.

In your facsimile you state that a Canadian resident individual, who also happens to be a citizen of the United States of America ("US"), invested in a flexible annuity product issued by a US life insurance corporation (the "US Tax Deferred Plan"). You indicate that the taxpayer is not subject to income taxes in the US on the income accumulating in the US Tax Deferred Plan until such time when withdrawals are made from the US Tax Deferred Plan. Further, you indicate that when the amounts are actually withdrawn from the US Tax Deferred Plan the accumulating income is deemed to be paid first before any payment, or part thereof, is considered to be a tax free return of premiums for US tax purposes. You also indicate that if any amounts are withdrawn from the US Tax Deferred Plan prior to time the individual reaches age 59 1/2 there will be a US tax penalty. You also indicate that the taxpayer has been a Canadian resident for several years files both Canadian and US income tax returns annually.

You are concerned that if Canada does not allow the annual accumulating income earned under the US Tax Deferred Plan to accrue on a tax deferred basis like the US, the ability of the individual to fully utilize any foreign tax credits ("ftc") in Canada may be lost since both the timing and amount of the income inclusion for tax purposes in Canada and the US will not be the same.

It is your view that should this occur the income will effectively be taxed twice, once in Canada on the deemed accruals under subsection 12.2(1) of the Act and once in the US when the withdrawals commence. Your question is whether the taxation of the annual accumulating income earned under the US Tax Deferred Plan can be deferred in Canada until such time as these amounts are subject to taxation in the US.

It is our understanding that your request relates to a completed transaction. Questions concerning the proper determination of the income tax consequences of completed transactions should normally be addressed to the taxpayer's relevant Tax Services Office ("TSO") and should include a complete description all the relevant facts and include all documentation that will assist that TSO in their review. Since your particular situation involves what you describe as a US Tax Deferred Plan and much information is missing or incomplete the determination of the income tax consequences related to this plan is not possible at this time and remains a question of fact. In order for the particular TSO to be able to review your situation the department would require information pertaining to the circumstances under which the taxpayer acquired their interest in the US Tax Deferred Plan and a description of the relevant US tax laws that are applicable to the plan.

Further, depending on the circumstances the US Tax Deferred Plan may be considered to represent a form of pension, employee benefit, or some other type of retirement arrangement and you will need to consider, for example, whether the US Tax Deferred Plan would be a "employee benefit plan"; a "retirement compensation arrangement" or a "salary deferral arrangement" as those terms are defined in subsection 248(1) of the Act. You will also need to determine whether such a plan or arrangement was held in a custodial capacity or by a trust since the taxation may be affected by this (see paragraph 94(1)(b) of the Act for example). Finally, such a review may also require consideration of the Canada-United States Tax Convention (the "Convention") currently in force between Canada and the US. Therefore, although we are not able to comment specifically on your fact situation, we can offer the following general comments that we caution may or may not apply to your particular situation.

General Comments

Where a taxpayer holds an interest in a life insurance policy, other than a life insurance policy described in paragraphs 12.2(1)(a), (b) or (c) of the Act, the taxpayer will be required to accrue income on such a policy either on an annual basis or triennial basis depending on when the interest in the policy was "last acquired". For policies last acquired after 1989 the accrual must be made on an annual basis and for policies last acquired before 1990 the accrual must be made on a triennial basis (see the discussion of the deemed acquisition rules below for the purpose of determining when such a policy may be considered "last acquired"). The term "life insurance policy" is defined in subsections 248(1) and 138(12) of the Act to include an annuity contract. While the term "interest in a life insurance policy" is not defined in the Act it generally refers to an ownership interest. Where subsection 12.2(1) of the Act applies, the amount of the accrual is based on the excess of the policy's "accumulating fund", as defined in section 307 of the Regulations to the Act, over its "adjusted cost basis", as defined in subsection 148(9) of the Act.

Where an individual who is resident in Canada owns an interest in an annuity issued by a foreign entity, as mentioned above, it remains a question of fact as to whether such a contract is considered to represent a foreign pension, employee benefit or some other type of retirement arrangement under the Act and whether the individual can be considered as the owner of the particular annuity (see brief discussion below). Pursuant to paragraph 4 of Article XVIII of the Convention, "annuity" is defined in to mean, "...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 the taxation in the Contracting State in which it was acquired." The term "pensions" is also defined in paragraph 3 of Article XVIII of the Convention to include any payment under a superannuation, pension or other retirement arrangement, Armed Forces retirement pay, war veterans pensions and allowances and amounts paid under a sickness, accident or disability plan, but does not include payments under an income-averaging annuity contract or any benefit referred to in paragraph 5."

Therefore, while it remains a question of fact as to whether a particular deferred annuity would be considered to be an annuity or a pension for the purpose of the Convention, the Convention does not automatically supersede the application of section 12.2 of the Act to a deferred annuity. As a result, except as described below, their remains a possibility for non-symmetrical taxation for which no relief exists under the current Convention. We also refer you to Interpretation Bulletin IT-87R2, Policyholder's Income From Life Insurance Policies dated February 15, 1996 if you require a more complete explanation of the accrual rules under section 12.2 of the Act.

Paragraph 7 of Article XVIII of the Convention may apply in certain situations 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 Convention 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. This rule was primarily intended to apply to Canadian resident beneficiaries of IRAs and US resident beneficiaries of RRSPs for example.

If it is determined that non-symmetrical taxation exists and the criteria outlined in Paragraph 7 of Article XVIII of the Convention is met then you could make a request to the competent authority of Canada. The International Tax Directorate of Revenue Canada is recognized as the competent authority of Canada for the purpose of making such requests and their mailing address is 25 McArthur Road, 2nd Floor Tower C, Vanier, Ontario, K1A 0L5.

Deemed Acquisition Rules

For taxation years commencing after 1992 subsection 128.1(1) of the Act provides rules that will apply where an individual immigrates to Canada. Pursuant to paragraph 128.1(1)(b) the individual will generally be deemed to have disposed of each property owned by that individual immediately before that time (other than certain types of property listed in subparagraphs 128.1(1)(b)(i) to (v) of the Act) for proceeds equal to the fair market value of the property at that time. Paragraph 128.1(1)(c) of the Act then deems the taxpayer to have reacquired each such property at a cost equal to the deemed proceeds. "Property" is defined in subsection 248(1) of the Act and would normally include an interest in a deferred annuity contract. As a result of these rules, if an individual owning an interest in a deferred annuity immigrated to Canada after 1992 the adjusted cost basis of the deferred annuity would normally increase such that only the increase in the accumulating fund that occurred after the individual becomes resident in Canada would be subject to the accrual taxation rules in section 12.2 of the Act.

However, where an individual immigrated to Canada owning an interest in a deferred annuity prior to 1993, the predecessor provision to subsection 128.1(1) of the Act, being subsection 48(3) of the Act, would not ordinarily result in a deemed a disposition and reacquisition of an interest in such an annuity since subsection 48(3) of the Act only applied to certain types of "capital property". Capital property is defined in section 54 of the Act to mean, inter alia, any property from which the gain or loss from a disposition would result in a capital gain or loss. Pursuant to subparagraphs 39(1)(a)(iii) and 39(1)(b)(ii) of the Act a disposition of an interest in a life insurance policy (except for that part of a life insurance policy that is deemed by paragraph 138.1(1)(e) of the Act to be a policyholder's interest in a segregated fund trust) will not result in a capital gain or loss to the taxpayer. Assuming the exception does not apply, the interest in the deferred annuity would not be a capital property. In this situation, since there would be no increase in the adjusted cost basis of the annuity when the taxpayer becomes a Canadian resident any increase in the accumulating fund of the policy that occurred before the taxpayer became resident in Canada would be subject to the accrual taxation rules in section 12.2 of the Act.

The foregoing comments are intended as a general discussion only which may or may not be relevant to the fact situation described in your letter. While we hope our comments are of assistance to you they do not 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
Manager
Financial Institutions Section
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch

c.c. International Tax Service Office