Barbados Case Study: Dual Compliant Life Insurance for Americans Living in Canada

By Charles C Gagnon, Partner, BCF Barbados (01/02/2014)

Because the United States taxes its citizens irrespective of where they reside, Americans living abroad are faced with having to comply with the tax regime of their country of residence as well as the complex US tax regime.

Complying with two tax regimes with different rules that were not designed to be compatible is a challenge for the financial and tax planner.  While the US tax treaties generally prevent double taxation, they offer no assistance in making common US tax planning techniques and vehicles compliant under the tax rules of the foreign country of residence.

Life insurance is one of the most commonly used financial planning tool in the world but the tax rules governing life insurance greatly vary among countries.

Because of the close economic and social ties between Canada and the US, a large number of American citizens live in Canada and are faced with having to comply with the laws of two highly complex tax regimes.

While Canadian and US life insurance tax rules have some similarities, they are far from being identical and contain major differences.  Therefore, compliance with the Canadian rules in no way guarantee compliance with the US rules and vice versa.  Up until recently, no insurer offered a dual compliant life insurance product.  Insurers have been deterred from entering this niche market because of the technical tax challenges involved in designing and offering a dual compliant product as well as the securities and insurance regulatory challenges involved.  While the latter challenges may prove difficult to overcome in the context of a retail product, they are somewhat easier to solve if the product is designed solely for the high-end private placement audience.

This gap in the life insurance market presented an opportunity for an insurer specialising in private placement life insurance (PPLI).  Amphora Life, a Barbados life insurer operating solely in the PPLI arena, has retained my Canadian firm and a US firm to jointly assist with the design of a dual compliant universal life product for Americans living in Canada.

The Technical Challenges

In Canada, the funds accumulating in a life insurance policy are not subject to annual taxation if the policy is not a ‘segregated fund policy’ within the meaning of Section 138.1 of the Income Tax Act (ITA) and meets the ‘exemption test’ contained in Section 306 of the Income Tax Regulations.

In order to benefit from similar tax-deferred build up in the United States, the policy must meet the ‘cash value accumulation’ (CVA) test or both meet the ‘guidelines premiums’ (GP) requirements and fall within the ‘cash value corridor’ (CVC) provided for under Section 7702 of Internal Revenue Code (IRC).  

The dual compliant product is designed to meet the Canadian exemption test as well as the CVA or the GP & CVC test.  The Canadian exemption test and the selected US test are run separately and the policy is required to meet both at all times.

If the policy is a ‘variable contract’, then it must also avoid the application of the investor control doctrine and comply with the ‘diversification requirements’ of Section 817(h) IRC.  For the purposes of the IRC, a life insurance policy is a variable contract if it provides for the allocation of all or part of the amounts received under the contract to an account, which pursuant to state law or regulations, is segregated from the general assets accounts of the company and the amount of the death benefit (or the period of coverage) is adjusted on the basis of the investment return and the market value of the segregated asset account.  The US concept of variable contract is somewhat similar to the Canadian concept of segregated fund policy in Section 138.1 ITA.  

American policyholders generally wish to have the protection afforded by a separate account and consequently, most universal life insurance policies issued by US carriers are variable contracts with underlying segregated accounts.  If the holder of a variable life insurance contract lives in Canada, then the funds accumulating in the contract are subject to annual taxation under Section 138.1 ITA.  This is one of the most common pitfalls encountered by Americans with US issued life policies moving to Canada.

In order to avoid this problem and obtain tax free accumulation in Canada, the dual compliant policy is not structured as a variable contract and its accumulating funds form part of the general assets of the insurer.  The absence of the security of a segregated account is the disadvantage of the dual compliant policy. In order to mitigate this disadvantage, prospective policy holders should exercise additional caution in the selection of the insurer and avoid insurers who carry on other lines of business with a higher risk profile (such as annuities and other products with guaranteed capital or return) that could adversely affect the value of their life policies.

There are also some major advantages to not having a variable contract.  Because the US investor control doctrine and the diversification requirements only apply to variable contracts and there is no Canadian equivalent to these rules, the dual compliant life policy does not have to comply with these two rules and provides the policyholder with a greater level of investment freedom and control than a US universal life insurance contract.

Federal Excise Tax Exemption

Absent a specific treaty exemption, the US imposes a one per cent excise tax on premium payments to non-US insurance companies with respect to life insurance and annuity contracts issued on the life of a US citizen or resident.  The obligation to withhold and remit this tax is imposed on the US policy holder and there are penalties for failure to withhold.

Paragraph 1(a) of Article 2 of the US - Barbados Tax Convention in conjunction with paragraph 5 of Article 24 permit an exemption from this US excise tax.  Therefore, premiums paid to a Barbados life insurer are exempt from US federal excise tax.

Insurance premiums paid by US citizens or residents to insurers located in countries that do not have a tax treaty with the US (eg, Bermuda, Cayman Islands and other tax haven countries offering PPLI) or whose tax treaty with the US does not contain a specific exemption are subject to this one per cent tax. Interestingly, the US – Canada Tax Convention contains no such exemption and therefore, Americans living in Canada are subject to this one per cent tax on the insurance premiums they pay to Canadian insurers.

Reduced Withholding Rates

An added benefit of using a Barbados insurer is that the funds accumulating in the policy may benefit from reduced withholding tax rates provided under Barbados’ tax treaties. 

Policy holders may therefore enjoy higher net investment returns than with an insurer located in a non-treaty country.

Attractive Rates

Premiums paid under an insurance policy on the life of a non-resident of Barbados are not subject to Barbados premium tax.

Unlike funds accumulating in a policy issued by a Canadian insurer or an insurer located in a non-treaty country, funds accumulating in a dual compliant policy issued by a Barbados insurer with no permanent establishment in Canada are not subject to the Canadian investment income tax (Part XII.3 ITA) by operation of the Canada – Barbados Tax Convention. 

Because of this favorable fiscal environment, a Barbados insurer can offer attractive rates to its foreign clients, which can translate into significant savings over the term of the policy.

In sum, Barbados’ tax treaties and regulatory environment make it an ideal jurisdiction for the provision of dual compliant life insurance solutions to Americans residing in Canada and elsewhere.

About the Author

Charles C Gagnon is a partner in BCF’s Barbados office. His main areas of expertise include: tax aspects of reorganisations and business acquisition and divestitures, strategic and estate planning for private corporations, structuring of investment in Canada and abroad, tax matters relating to immigration and emigration, international tax planning, wills and trusts.