The Taxation of Non-Registered Segregated Funds

The Taxation of Non-Registered Segregated Funds Segregated funds (also referred to as individual variable insurance contracts, or IVICs) are an appropriate part of many Canadians portfolios. In very simple terms, segregated funds are investment funds offered by life insurance companies. Segregated funds invest in a portfolio of securities (equities, debt securities, cash and derivatives, as well as underlying funds including other mutual and segregated funds) on behalf of policyholders. These funds are held separately from the insurer s general assets. Because of fluctuations in the market value of the assets held by the segregated fund, the value of the segregated fund will fluctuate. Thus, the inclusion of various insurance benefits (e.g., maturity and death benefit guarantees) becomes an important feature of these funds. Segregated funds and mutual funds have many similarities. Segregated funds are often thought of as the life insurance industry s equivalent to mutual funds. However, there are important distinctions, including the tax treatment. Investors contemplating acquiring investment funds should seek the information from their investment advisor about the features of both segregated funds and mutual funds before deciding which is most appropriate. Segregated funds are offered to policyholders through a life insurance policy or through an annuity contract. This lets the policyholders name beneficiaries, and gives them potential creditor protection provided under the provincial insurance laws. Additionally, there is the potential for probate bypass, which would result in savings of both time and probate fees. This document focuses on personally owned segregated funds. While segregated funds can be acquired on either a non-registered or registered basis, this document focuses on only non-registered segregated funds. I. General Discussion of Rules Relating to Income Allocation A segregated fund is deemed an inter vivos trust for tax purposes. 1 (It may also be referred to as related segregated fund trust. 2 ) The insurer is deemed the trustee and the policyholders are considered the beneficiaries. 3 The property and income of the segregated fund are deemed to be that of the trust and not the insurer, and the trust income is deemed to be an amount that has become payable in the year to the beneficiaries and thus flowed through to the policyholders under the rules applying to inter vivos trusts. 4 Since inter vivos trusts must have a December 31 st year-end, income of the trust, as calculated on a calendar year basis, will be flowed out to policyholders. It is important to know what is meant by flowed through. Essentially, the segregated fund will not have any taxable income in the year. With this passthrough approach, the income and capital gains (or losses) realized by the fund are allocated, that is, deemed to be payable to the beneficiaries in that year. The beneficiaries will include these allocated amounts in their taxable income, even though the income was not actually distributed (i.e., paid out) to them. An allocation can be made at any time in a year, 1 See paragraph 138.1(1)(a) of the Income Tax Act (Canada) (ITA). 2 See paragraph 138.1(1)(a) of the ITA. 3 See paragraphs 138(1)(b) and (f) of the ITA. 4 See paragraph 138.1(1)(b) and (f) of the ITA. PC 6001-10-2006

provided it is in accordance with the terms of the segregated fund policy. (While actual distributions can be made, these are uncommon.) There are no specific tax rules governing the calculation of the income that must be allocated. The tax rules instead specify that the amount in respect of any particular beneficiary is equal to the amount determined by reference to the terms and conditions of the segregated fund policy. 5 In a recent technical interpretation, Canada Revenue Agency (CRA) confirmed that It is the terms and conditions of the segregated fund policy that would normally determine the method and timing of the allocation. 6 Most insurers will employ one of three methods to allocate income: (1) pro-rata basis by units to policyholders of record on the allocation date, (2) time-weighted average basis (also referred to as exposure units method, or (3) daily participation. The application will vary from insurer to insurer, and perhaps even fund to fund. For example, with method (1), different periods could be chosen (one insurer may allocate income each month to policyholders who held units on a specific date in that month and another insurer may allocate income once annually to policyholders who held units on a specific date in that year). Let s look at method (2) and assume that it is applied on an annual basis. Assume that Sam holds 1,000 units for the whole month of January. The other policyholders hold 99,000 units throughout the year. When we look at how much of the annual income would be allocated to Sam using method (2), it would be 0.086% of the fund s income. (This has been calculated as (31 x 1,000)/(31 x 1,000 + 365 x 99,000)). Thus, when the trustee is allocating income in the year to the policyholders, Sam will be allocated an amount, even though he no longer owned them at the time the actual allocation was being done. This method estimates the amount of the income the fund earned while the policyholder was in the fund and allocates it proportionately. Now let s look at method (1) and assume that the allocation of the entire year s income is based on policyholders of record on a specific allocation date. Consider Anne s situation: she acquires her 1,000 units on December 1st. She was a policyholder of record on the allocation date, which occurred in December, at which time other policyholders held 99,000 units. Anne would be allocated an amount based on her unit holdings as at the record date. Since Anne holds 1% of the outstanding units on that date, she would be allocated 1.0% of the income for the entire year, even though she held the units for only a brief period in that calendar year. (No amount would be allocated to Sam, since he did not hold any units as at the allocation date.) The method of allocation will have a bearing on decisions as to when units in a segregated fund should be acquired or sold. With method (3), units outstanding at the end of the day share in that day s income. Thus, of the three methods, it strives for the greatest precision. However, it creates the greatest administrative burden and is thus the most costly. Some might also view it as being the most error prone of the three methods (e.g., dealing with backdated transactions in the context of income allocation.) Segregated fund investors and their advisors should seek to arrive at a clear understanding of allocation methods. These may have a significant impact on their tax liability, especially in the years in which a significant number of units are acquired and/or sold. Let s assume that Anne (a resident of Ontario) bought her 1,000 units on December 1, 2005 at $10.00 each. The segregated fund allocated income annually based on units held on an allocation date of December 2, 2005. Since Anne held her units on that date, she had the following allocation: Taxable dividends of $0.40 per unit (actual dividends of $0.32 per unit); capital gains of $0.30 per unit; and, $0.10 5 See paragraph 138.1(1)(f) of the ITA. 6 See CRA Technical Interpretation # 2005-0156951E5, dated November 3, 2005. 2

per unit of foreign income. Thus, Anne who is in the top tax bracket had taxes payable of $21.63 (that is, $32.00 x 31.34% + $30.00 x 23.2% + $10.00 x 46.41%) on the income allocated to her. As discussed in III below, the ACB of her 1,000 units will increase by $72.00 (that is, $32,00 + $30.00 + $10.00), or $0.72 per unit. Of course, the NAV of the units also reflects the income that the segregated fund has received to date (as well as any unrealized capital gains relating to the underlying securities). Anne paid $10.00 for each unit, and thus had an initial ACB of $10.00 per unit. With the allocation, her ACB increases to $10.72 per unit, while she has a virtually unchanged NAV of $10.00 per unit (assuming there are no further unrealized gains). Let s assume that Anne then sold her units on January 1, 2006. The underlying securities in the fund had not appreciated from December 2005. She will realize a capital loss at that time, since the amount that the NAV has increased by will be less than the increase in the ACB of the units. Assuming that she has other capital gains, she will realize some tax savings from applying the capital loss. It is important to realize that some of the income that had been allocated to her was taxed at higher rates than capital gains rates (i.e., the dividends were taxed at 31.34% and the foreign income was taxed at 46.41%, with both these rates exceeding the capital gains tax rate of 23.2%.) Even if Anne s NAV had increased by an amount equal to the increase in her ACB, she would still be worse off because of the difference in the tax rates. Where a segregated fund does more frequent allocations (say monthly), there should be less of a gap in what a policyholder has added to the ACB of their units and the increase they have in NAV per unit. II. Income Allocation Rules As stated above, the segregated fund trust is not taxable itself. Its income (net of expenses) is allocated out to the policyholders. The characterization of the income remains intact. Thus, preferential tax treatment remains in place for dividends from taxable Canadian corporations and capital gains. Let s look at these different sources. (While an insurer may choose to charge expenses directly to policyholders as withdrawals, most insurers net expenses against income.) When the insurer offsets expenses against various types of income, they are generally offset against the most heavily taxed types of income first. Thus, the sequence would typically be: interest, dividends from corporations resident in Canada, and then capital gains. The insurer will want to offset expenses against foreign income last because this may result in the policyholder s being able to claim less than the full amount of the foreign tax credit that would otherwise be available. The only exception to the allocation rules relates to non-capital losses realized by the trust. (Non-capital losses could arise where management and other expenses of the fund for a year exceed income and capital gains of the fund for that same year.) Currently there is no provision in the Income Tax Act (Canada) (ITA) allowing for the allocation of these to policyholders. While non-capital losses may be offset against the income of the trust, there currently are no carry-forward provisions. The industry has made representations to the Department of Finance in this regard. (Approaches being put forth include allowing the trust to apply non-capital losses again the trust s income within the usual carryover period, or perhaps allowing non-capital losses to be allocated to the policyholders.) The policyholder will receive a T3 slip from the insurer. (Residents of Quebec will also receive a RL-16 slip for purposes of preparing the Quebec provincial tax return.) The income that the unit trust has allocated to them will be reflected on this slip. The tax slips also include all other amounts relating to segregated fund ownership that the policyholders must report. By way of example, the capital gain (or loss) from the disposition of the units is also reflected on the T3 slip (and RL-16 slip). Hence, the policyholder does not need to go through the exercise of establishing what the proceeds of disposition, adjusted cost base (ACB) and costs of disposition are for dispositions in the year. This exercise could be grueling where there have been a large number of 3

dispositions (perhaps because of participation in a Systematic Withdrawal Plan, or SWP). This makes preparing tax returns far easier the policyholder simply takes the amounts shown on the T3 slip (RL-16 slip) and includes these on the tax return. Dividends from Other than Taxable Canadian Corporations and Interest (Except Foreign Income) Dividends from other than taxable Canadian corporations and interest income do not receive preferential tax treatment. Thus, the insurer will typically offset fund expenses against this source to the maximum extent possible. The net amount (if any) will be allocated to the policyholders. This amount will appear as Other income on the T3 slip (RL-16 slip). Dividends from Taxable Canadian Corporations Dividends from taxable Canadian corporations receive preferential tax treatment. Under current rules, the grossed-up dividend (125% of the actual dividend) is included in taxable income and subject to tax. A dividend tax credit (DTC) for 13-1/3% of the grossed-up dividend (or 16-2/3% of the actual dividend) is available at the federal level. (DTCs are also available at the provincial level, with the rate varying by province.) For individuals in the top tax bracket, the effective tax rate is approximately 30%. (The exact rate will vary by province.) The 2006 Federal Budget contained proposals to modify the DTC mechanism. Eligible dividends will be grossed up by 45% - thus 145% of the actual dividend is included in taxable income and subject to tax. 7 A DTC for 18.96% of the grossed-up dividend (or 27.5% of the actual dividend) is then available. 8 This means people in the top tax bracket enjoy an effective tax rate reduction of approximately 5% at the federal level (4% for residents of Quebec). (The full impact of this measure can only be assessed once it is known how the provinces will proceed.) As stated above, insurers typically allocate expenses so that they are applied against the highest taxed income first. Thus, expenses will typically only be offset against the (actual not grossed-up) dividends to the extent that no other income that would be subject to higher tax rates remains to be allocated. Where the insurer allocates these dividends (net of expenses) to policyholders, the policyholder will include the grossed-up dividend in their income and will claim the appropriate dividend tax credit. 9 On the T3 slip (RL-16 slip) for 2005 and earlier years, there were separate fields for Actual amount of dividends, Taxable amount of dividends and Federal dividend tax credit. CRA has not yet indicated the changes that will be made to the T3 slip (RL-16 slip) for 2006. Capital Gains and Losses Capital gains and losses of the segregated fund trust that have arisen from the disposition of securities held by the fund (i.e., trading gains or losses) are deemed to be those of the policyholders. 10 (This allocation of capital losses is a unique feature of segregated fund trusts. Mutual fund trusts cannot allocate capital losses.) A policyholder may realize some tax savings to the extent that the allocated capital losses can be offset against capital gains realized from disposition of other capital assets. Net capital losses can be carried 7 See proposed definition of eligible dividend in subsection 89(1), as well as proposed subclause 82(1)(b)(ii), both included as part of Legislative Proposals and Explanatory Notes Relating to Income Tax Dividend Taxation (June 29, 2006 Draft Legislation), as released June 29, 2006. 8 See proposed subsection 121(b) of the June 29, 2006 Draft Legislation. 9 See subsection 104(19) of the ITA. 10 See subsection 138.1(3) of the ITA. 4

back three years, or carried forward indefinitely. 11 Special rules exist for net capital losses in the year of death. These may be offset against all sources of income in the year of death, or in the immediately preceding taxation year, with the net capital losses being applied being reduced by the amount of any capital gains exemption previously claimed. 12 Where a policyholder has realized a gain from the disposition of units held by them (i.e., on redemptions), and the segregated fund trust has trading gains, the trading gains will typically first be allocated to the redeeming policyholder. Any balance will be allocated to policyholders according to the allocation policy of the fund. Thus, when we look at capital gains (or losses) reported on a T3 slip (RL-16 slip), they include the gains (or losses) relating to the disposition of any units by the policyholder, plus an allocation of remaining trading gains (or losses) realized by the fund. The insurer will typically not want to allocate expenses against the capital gains. Remember that with the 50% inclusion rate for capital gains, while $1 of expense would offset $1 of capital gain, this results in only a $0.50 reduction to the policyholder s taxable capital gain. The T3 slip (RL-16 slip) contains a field described as Capital gains. In Quebec, capital losses allocated to a policyholder will be shown as a negative amount in the Capital gains box. However, on the T3 slip, the insurer will enter the amount of the capital loss and a Box Number into a separate area of the form. (For 2005, Box 37 was used to denote Insurance segregated fund capital losses.) For both Federal and Quebec tax purposes, the amount of any foreign capital gain included in Capital gains is identified. On both slips, a footnote should appear identifying the foreign portion, if any. This is relevant for purposes of the foreign tax credit calculations. Foreign Income Foreign income does not receive preferential tax treatment. Full rates of tax apply. However, the policyholder may benefit from being able to claim a foreign tax credit for taxes paid to a foreign jurisdiction. The insurer will separately allocate both the foreign income and foreign taxes paid to the policyholder. 13 The insurer will not want to offset fund expenses against this source, since this may have an impact on the foreign tax credits that the policyholder is able to claim. The policyholder will report the foreign income and claim the appropriate foreign tax credit on the tax return. (In certain circumstances, the taxpayer can claim a deduction in computing income for foreign taxes that cannot be utilized as a foreign tax credit. 14 ) On the T3 slip (RL-16 slip), the trustee will enter the appropriate Box Number and amount for Foreign non-business income and Foreign non-business income tax paid. (Boxes 25 and 34, respectively, on the T3 slip. Boxes F and L, respectively, on the RL-16 slip.) General Comments on Allocation of Income Prospective policyholders thinking about buying should always review the fund information that insurers provide. Information on investment strategies and objectives will help the prospective policyholders determine the nature of the income that may be expected. For example, where a fund invests primarily in Canadian equities, the income that is allocated may be dividends that can receive preferential tax 11 See paragraph 111(1)(b) of the ITA. 12 See subsection 111(2) of the ITA. 13 See subsections 104(22) and (22.1) of the ITA. 14 See subsections 20(11) and (12) of the ITA. 5

treatment, plus capital gains (or losses). Prospective policyholders should also review portfolio turnover rates, as these may indicate whether prospective policyholders can expect an allocation of capital gains (or losses). When determining the most preferential type of income, too often the focus is only on what is appropriate for those in the top tax bracket. Here we see that dividends from taxable Canadian corporations (prior to changes announced in the 2006 Federal Budget) are taxed at a higher rate than are capital gains. However, remember that the greater the tax effectiveness of these dividends the lower the taxpayer s tax bracket. This is because the DTC (at both federal and provincial levels) is constant, irrespective of the tax bracket. For example, when we look at taxable incomes of approximately $50,000, the effective tax rate for 2006 (prior to changes announced in the 2006 Federal Budget) for these dividends may not vary significantly from that for capital gains (e.g., Ontario: Dividends at 15.85% versus capital gains at 15.58%; Quebec: Dividends at 20.51% versus capital gains at 19.19%; Alberta: Dividends at 15.33% versus capital gains at 16.0%). This comparison must be done on a province-by-province basis, and revisited once the jurisdiction has made a decision on whether it will proceed with changes to the DTC mechanism. III. Adjusted Cost Base of the Trust Units Units of segregated fund trusts are considered capital property. Thus, a capital gain or loss will be calculated when the units are disposed. (See discussion in section VII about Successor Annuitants.) Situations that would result in a disposition include where: The policyholder switches between funds offered pursuant to the same contract; There is a substitution of funds in the contract; There is the closure of a fund; The interest in the policy is surrendered in whole or in part; There is a transfer of the interest in the policy; A maturity option is exercised; or, The annuitant dies. (Dispositions occurring upon the exercise of a maturity option are discussed in IV below, and those occurring upon death are discussed in V below.) The complexities associated with the ACB calculations are the insurer s concern. The insurer must track each policyholder s ACB, on a policy-by-policy basis. This is necessary because it is the insurer who calculates the capital gains or losses arising on a disposition of units. As stated above, these amounts are added to the T3 slip (RL-16 slip for residents of Quebec) the insurer is already issuing which contains the income (and capital gains or losses) being allocated to the policyholder for the year. Nonetheless, the calculation should be of interest to the policyholder, as it has a direct bearing on the calculation of capital gains and losses, and hence the policyholder s payable taxes payable. In simple terms, the ACB is calculated as follows: Premiums paid, Plus: a) income allocated to the taxpayer pursuant to paragraph 138.1(1)(f), b) amounts calculated under subparagraph 138.1(g)(ii) c) capital gains deemed to have been allocated under subsection 138.1(4) 6

d) capital gains allocated to the taxpayer under subsection 138.1(3) 15 Less: e) capital losses deemed to have been allocated under subsection 138.1(4) f) capital losses allocated to the taxpayer under subsection 138.1(3). 16 Premiums Paid Not all amounts paid by the policyholder will be premiums paid for purposes of calculating the ACB. Acquisition costs (e.g., front-end load commissions) are not part of the ACB. 17 These should be tracked separately. They are treated as capital losses when units are disposed of in whole or in part. Annual Income Allocations to the Policyholder Item a) represents the interest and dividend income (including that from foreign sources) that has been allocated to the policyholder each year. In the case of dividends from taxable Canadian corporations, the actual amount of the dividend (not the grossed-up amount) is added to the ACB. Items d) and f) represent the realized capital gains and losses of the fund that have been allocated to the policyholder each year. The full amount (not just 50%) of the capital gain is added to the ACB, whereas the full amount of capital loss is deducted from the ACB. Since the allocated income (and allocated capital gains and losses) are added or deducted from the ACB, the effect is to eliminate double taxation. Were the adjustments not made to ACB, the policyholder would be taxed twice. Remember that the allocated income and capital gains are typically not paid out. This increases the net asset value (NAV) per unit (or decreases in the case of capital losses). Capital Gains or Losses Realized by Policyholder Upon Disposition of Units As stated above, if there are redeeming policyholders, they typically are the first to be allocated the capital gains realized by the segregated fund (i.e., the trading gains ). The balance is allocated to the remaining policyholders. There may, however, be situations where the trading gains realized by the fund in the year are less than gains realized by the departing policyholders. Double taxation is avoided by virtue of a special election that is available to the segregated fund trust. 18 Hence, the adjustment required by c) and e). These are best explained by looking at an example. Let s assume that John held units having a significant accrued gain. He sold 2,000 units at a time when the NAV was $15.00 per unit and the ACB was $10.00 (assume that there are no surrender charges). John realized a capital gain of $10,000. This amount forms part of the allocated capital gains that are reflected on John s T3 slip (RL-16 slip). The fund realized trading gains of only $3,000 in that year, all of which it allocated to John. However, the capital gain included on John s T3 slip (RL-16 slip) exceeds the capital gain of the fund by $7,000. In essence, John has realized gains of $7,000 that the segregated fund itself has not realized. Special rules in the ITA allow the segregated fund to elect to sell specific assets in order to realize a $7,000 capital gain. (Rules dealing with the mechanics of this election are beyond the scope of this document.) This $7,000 gain will also be allocated to a policyholder who redeemed units in the year, in this case to John. The $7,000 is added to the ACB of his units, thus eliminating what would be his realized gain. Now, when we look at John, the $7,000 will instead represent an additional allocated capital gain 15 See paragraph 53(1)(l) of the ITA with respect to additions to the ACB. 16 See subparagraph 53(2)(q) of the ITA with respect to deductions to the ACB. 17 See subclause 138.1(1)(e)(ii)(B) of the ITA. Acquisition fees are defined in subsection 138.1(6) of the ITA. 18 See subsection 138.1(4) of the ITA. 7

from the fund. At the same time, the fund will be deemed to reacquire assets held by it for an additional $7,000. Thus, when they are eventually sold, the capital gain allocated to remaining policyholders will be $7,000 less. If instead of accruing a gain, John had accrued a significant loss on the units when he disposed of them, the reverse would be true. Again, the special election may be made. Note that there are special superficial loss rules that may come into play. The segregated fund cannot trigger losses exceeding those that are required to match the policyholder s losses occurring on redemption. If there were insufficient accrued losses on the assets held by the segregated funds, another election would be available. If this election is used, the ACB of the assets held by the fund are reduced on a prorata basis, by the amount of loss that is required to match the losses incurred by the redeeming policyholders. 19 Transfers by Insurer of Amounts to/from Segregated Fund An insurer may transfer amounts to and from its segregated funds where it offers life insurance policies in which the benefits under the policy are a combination of both life insurance and segregated funds. Where this happens, the ACB of the segregated fund units will be adjusted. (This is item b) above.) IV. Maturity of Contract At contract maturity, the tax consequences of two events need to be considered. The first relates to any maturity benefits that may be payable at that time. The other relates to the commencement of the annuity. Maturity Benefit Segregated fund contracts provide a guarantee at maturity. Mutual fund contracts do not offer this valuable feature. The maturity benefit will vary from insurer to insurer, and prospective policyholders should read the material provided by the insurer (including the contract) to gain a clear understanding of the maturity benefit. Most contracts provide a minimum 75% guarantee of the return of net premiums upon maturity. Net premiums are the sum of premiums paid less the sum of proportional reductions for prior surrenders. By way of background, the 75% minimum is standard, as this avoids segregated funds being regulated as securities. 100% maturity benefits are less common in newer contracts because of the changes to capital reserve requirements that were recently made by some of the supervisory authorities. There are two types of maturity benefits: those offered on a contract basis, and those offered on a deposit basis. These are discussed below. i. Contract based maturity benefit Generally, a minimum number of years (typically ten) must elapse before a guarantee is available. Most segregated fund contracts automatically terminate at a specific age (for example, when the annuitant turns 90 or 100), with an annuity being acquired at that time. A maturity benefit could come into play at that time. It is also possible that the policyholder may choose an earlier annuity commencement date (perhaps upon the annuitant s or policyholder s attaining a specific age). A maturity benefit could be payable at that time (subject of course to the minimum ten years having elapsed by that time). Where maturity benefits are provided on this basis, they are usually referred to as contract based guarantees. 19 See subsection 138.1(5) of the ITA. 8

Until relatively recently, few maturity guarantees were paid, and there were different views as to how these should be treated for tax purposes. Matters were not helped by the fact that the ITA did not specifically address guarantees and the fact that there were no tax cases dealing with the treatment of these guarantees. Moreover, until relatively recently, CRA had not publicly taken a position with respect to the appropriate tax treatment. Insurers generally use one of two methods for dealing with the maturity benefit. Irrespective of the method chosen, it is now generally accepted that the maturity benefit should be accorded capital treatment. The simplest method has the insurer pay the policyholder directly. (This may be more common where the guarantee is contract based.) The second method involves allocating additional units to the policyholder. The insurer then contributes additional assets to the fund. The policyholder later terminates the policy, and redeems both the original units plus the additional units. This may be more common where the guarantee is deposit based. Let s look at the first method. Here we will assume that Marie had acquired 20,000 units on a no-load basis for $100,000. At the annuity commencement date, the value of the units had declined to $65,000. (With a 75% guarantee, she is entitled to a maturity benefit of $10,000.) Assuming that her ACB is also $100,000, her capital loss on the disposition of the segregated fund units would be $35,000. This capital loss will be dealt with as discussed in III above (i.e., the capital losses are deemed to have been allocated to her). The insurer then makes a $10,000 payment directly to Marie. CRA has held that this $10,000 is to be treated as a capital gain. Thus, Marie has $65,000 cash from the sale of the units, as well as the additional $10,000 received directly from the insurer. She has recovered 75% of the money she originally invested. The $10,000 capital gain arising from the payment made by the insurer offsets the capital loss of $35,000 that was allocated to her on the disposition of all her units. 20 Thus, on her tax return she has a capital loss of $25,000. There is no clear guidance as to how the $10,000 capital gain should be reported by the insurer. Some insurers may include the $10,000 on a T3 slip. Marie may be able to realize some tax savings if she is able to apply the $25,000 capital loss against capital gains that she has realized from the sale of other assets in the year or in the carry-over period permitted for net capital losses. In the example above, we assume that Marie had not previously received T3 slips (RL-16 slips) for income (or capital gains or losses) allocated to her. Had this been the case, the T3 slip (RL-16 slip) for the year the maturity benefit was received would reflect a greater capital loss, as these previously allocated amounts would have increased the ACB of the units, and this would have to be reversed. Remember that the amounts reported on the slips were allocations, not distributions. Thus, the reversal is necessary! (The reversal is not perfect. Amounts previously allocated to Marie may have been taxed at other than capital gains rates, whereas the reversed amounts form part of the capital gain (or loss) reported on the tax slip.) ii. Deposit based maturity benefit Deposit based guarantees will vary. For purposes of this discussion, let s assume that the contract provides that a maturity benefit will be provided once a specific period (say ten years) has elapsed from the date of the deposit. At this time, let s further assume that the value of Sam s original deposit of $100,000 has declined by $35,000. Hence, under the terms of the maturity benefit, Sam is entitled to $10,000. Let s assume that the NAV is $10 per unit at that time, and hence Sam receives an additional 1,000 units. 20 See Technical Interpretation # 9817165 dated February 18, 1999. 9

Where the insurer contributes the additional $10,000 to the segregated fund, the insurer is considered to have acquired an interest in the segregated fund trust. 21 CRA is of the view that there are no immediate tax implications to the policyholder at this time so long as the policyholder did not receive nor was entitled to receive all or any part of this $10,000. 22 Let s assume that the policyholder later sold the units for $75,000 and that the ACB of the units is $100,000. Sam would realize a capital loss of $25,000 when he disposed of the units. Under the allocation rules discussed above, a capital loss of $25,000 is allocated to Sam and reported on the T3 slip (RL-16 slip) issued to Sam. Again, as with Marie, if his ACB was something other than $100,000 because of previous allocations, the capital loss would reflect a reversal of these amounts. V. Death of Annuitant Where the annuitant dies, the segregated fund contract generally will terminate. (See discussion in VII below dealing with Successor Annuitants.) Death benefits are among the valuable features of segregated funds. Prospective policyholders should carefully read the material provided by the insurer (including the contract) to gain a clear understanding of the exact nature of the death benefit. In very general terms, many insurers offer a death benefit of 100% of the net premiums. However, a lesser amount (say 75%) may be offered to policyholders where the annuitant has attained a specific age at the time the contract is acquired. (For example, the death benefit may be 75% where the annuitant is age 80 when the contract is acquired.) As with the maturity benefit, the death benefit is accorded capital gains treatment. The tax consequences are as described in the discussion of maturity benefits. 23 While we understand that some insurers are treating the top up as tax-free, this does seem to be contrary to the position that has been expressed by CRA in the recent technical interpretations issued by it. VI. Annuity Commencement Date A segregated fund contract will have an Annuity Commencement Date. When this date occurs, the units of the segregated fund are disposed and an annuity (typically a single life annuity) is acquired. Thus, the policyholder will have a capital gain (or loss) from the disposition of the units. The terms of the segregated fund contract will specify whether a maturity benefit is available at that time. The insurer will generally issue an annuity contract at the same time. VII. Successor Annuitants Many insurers offer segregated fund contracts that contain a valuable Successor Annuitant feature. This allows the policyholder to appoint a person who becomes the annuitant once the original annuitant dies. The contract does not terminate. While a death benefit is thus not payable upon the death of the original annuitant, periods applying to any maturity benefits are not interrupted. 21 See Technical Interpretation # 9905255 dated June 17, 1999. 22 ibid 23 See Technical Interpretations # 9817165 dated February 18, 1999 and # 9905255 dated June 17, 1999. 10

If the successor annuitant is a spouse or common-law partner within the meaning of the ITA, the spousal rollover rules could come into play, provided all of the conditions specified in the ITA are met. 24 Where the spousal rollover is available, the insurer will generally assign a new contract number to the policy. However, there is no deemed disposition of the units. The ACB of the deceased spouse will become the ACB of the surviving spouse. Two T3 slips (RL-16 slips) will be issued for that year. The deceased annuitant will receive a slip (or slips) for allocations up to the date of death. The successor annuitant will receive a slip (or slips) for allocations relating to the period after death. Where the spousal rollover is not available because the successor annuitant is not a spouse, there will be a disposition for tax purposes. A new contract number will generally also be assigned. There will be a disposition of the segregated funds units at Fair Market Value (FMV) at death. Thus, capital gains (or losses) on a disposition of the units will be calculated. The successor annuitant s ACB will be the FMV of the units at that time. Again, two T3 slips (RL-16 slips) will be issued for the year. There may be situations where the surviving spouse is not designated as the successor annuitant, yet a tax-free spousal rollover is sought. Where the segregated fund contract terminates upon the death of the first spouse, this tax-free rollover is not available. This is because there is a disposition of the segregated fund contract for legal purposes, which takes precedence, with there being a resulting disposition of the contract for tax purposes. The insurer would calculate the appropriate capital gain or loss, taking into account any death benefit guarantees provided by the segregated fund contract. VIII. Other Considerations Interest Deductibility Generally, interest paid or payable on borrowed money used to acquire an interest in a life insurance policy is not deductible. However, special rules were introduced into the ITA in 1991, effective for the 1987 and later taxation years. These specify that a life insurance policy does not include a policy that is an annuity contract all of the insurer s reserves for which vary in amount depending on the fair market value of a specified group of properties (i.e., for segregated funds that are also considered annuity contracts). 25 CRA views that interest paid on loans to acquire segregated funds is deductible, if the other conditions for interest deductibility are met. 26 In 2003, CRA issued an interpretation bulletin dealing with interest deductibility. 27 In this bulletin, CRA looked at investments bearing a stated dividend or interest rate, and stated that based on the Ludco decision, interest deductibility will not be denied (nor restricted to the amount of the income). 28 In the case of common shares, CRA normally considers interest relating to their purchase to be deductible on the basis that there is a reasonable expectation of dividends. 29 CRA then went on to say that these comments are also generally applicable to investments in mutual fund trusts and mutual fund corporations. 30 Based on current legislation, it is the industry s view the interest charges relating to the acquisition of segregated fund units should thus also be deductible (provided of course that the segregated fund contract is also considered to be an annuity contract). 24 See definition of common-law partner in subsection 248(1) of the ITA, as well as extended meaning of spouse in subsection 252(3) of the ITA. 25 See paragraph 20(2.2)(c) of the ITA. 26 See paragraph 20(1)(c) of the ITA. Also see Technical Interpretation # 9813845 dated November 24, 1998. 27 See Interpretation Bulletin IT-533 Interest Deductibility and Related Issues dated October 31, 2003 (IT-533). 28 See paragraph 31 of IT-533. 29 ibid 30 ibid 11

While the Department of Finance (Finance) did propose changes to the interest deductibility rules in 2003 (the Reasonable Expectation of Profit (REOP) rules), we cannot predict whether these proposals will be proceeded with. Under these rules, in a year in which a taxpayer incurred investment expenses in excess of investment income, limitations could come into play. 31 (For this purpose, capital gains (and losses) are not included as investment income.) Quebec in its 2004 Budget introduced its own set of rules relating to interest deductibility. 32 These took effect in 2004, with special proration rules applying for 2004. Under these rules, investment expenses (including interest income) will be capped at the investment income reported for that year. There is a three-year carry-back and indefinite carry-forward of amounts that cannot be deducted in the year. Nondeducted investment expenses can be deducted in the year of death. Under the Quebec rules, taxable capital gains are included as investment income. Other income distributed by the segregated fund would also be property income, and would thus enter into this calculation. In the case of dividends from taxable Canadian corporations, it is the taxable amount that forms part of investment income, not the actual amount. Investment Counsel Fees The ITA has specific rules relating to the deduction of fees paid to investment counsel. To be deductible, the fees must relate to shares or securities. 33 It is the industry s view that it is inequitable that fees relating to segregated funds are not accorded similar treatment. Representations have been made to Finance in this regard. Donations of Segregated Fund Units The 2006 Federal Budget contained proposals to reduce the capital gains inclusion rate to zero for donations of publicly traded securities to charitable organizations and public foundations. 34 (Previously the inclusion rate for such donations was 25%.) When we look at securities currently qualifying for the 25% inclusion rate, they include an interest in a related segregated fund trust (within the meaning assigned by paragraph 138.1(1)(a). 35 Accordingly, where a taxpayer donates a segregated fund unit, no capital gains tax will be payable with respect to this donation. Furthermore, the charity will be able to issue a donation receipt for the FMV of the segregated fund units, provided that the donor did not receive any amount of advantage in making the donation. 36 CRA does not offer guidance with respect to how this would impact the tax reporting processes for segregated funds. 31 See Department of Finance Release 2003-055 Department of Finance Releases Draft Proposals Regarding the Deductibility of Interest and Other Expenses dated October 31, 2003. 32 See article 726.6(a.2) of the Quebec Taxation Act. 33 See paragraph 20(1)(bb) of the ITA. 34 See page 230 of Supplementary Information and Notice of Ways and Means Motion), tabled as part of the 2006 Federal Budget. Draft legislation is not yet available. [Lea to check Bill C13] 35 See subsection 38(a.1) of the ITA. 36 See proposed subsection 248(31) to (41), as contained in the Revised Legislative Proposals Released Relating to the Taxation of Non-Resident Trusts and Foreign Investment Entities and Other Technical Amendments to the Income Tax Act, as released by Finance on July 18, 2005. 12

IX. Summary Specific tax rules apply to the taxation of segregated funds. This document is lengthy because it explains the behind the scenes calculations that the trustee of the segregated fund must do to allocate income (and capital gains and losses) to the policyholder. Remember that the policyholder s tax return preparation process is simple, in that he or she simply reports amounts included on the T3 slip (RL-16 slip in Quebec). A review of tax considerations is only part of a prospective policyholder s decision process. The prospective policyholder and investment advisor should review all material (including the contract) provided by the insurer to determine whether an investment is appropriate. Segregated funds offer insurance benefits that make them attractive to many prospective policyholders (for example, the selfemployed professional who may be seeking creditor protection) and should thus be included when reviewing possible investments. This document is intended for general information only. It should not be construed as legal, accounting, tax or specific investment advice. Clients should consult a professional advisor concerning their situations and any specific investment matters. While reasonable steps have been taken to ensure that this information was accurate as of the date hereof, and its affiliates make no representation or warranty as to the accuracy of this information and assume no responsibility for reliance upon it. 13