ADVISING
the
Client
FINANCIAL PLANNING
Taxation of Segregated Funds
INTRODUCTION
When an investor invests in a fund-on-fund type segregated fund, the
cash is used by the insurance company to purchase units of underlying
mutual funds. As a result, the investor does not own units in the
mutual fund directly. Rather, it’s the insurance company through the
segregated fund that owns the mutual fund units. In buying a segregated
fund contract, the investor has become a policyholder, not a unit holder.
The contract is actually an annuity contract governed by provincial
insurance laws.
• Since every segregated fund is a separate trust (for tax purposes),
switching between different segregated funds in a non-registered
contract is a taxable event. These transactions will not be treated as
taxable dispositions when they occur within a registered contract or
when funds are transferred to another permitted registered contract.
The SunWise structure allows for non-taxable switches between the
various guarantee settings within the same non-registered underlying
funds (e.g. a switch from the Full Guarantee CI Harbour Fund to the
Combined Guarantee CI Harbour Fund should not trigger a taxable event).
How are segregated fund guarantees/benefits taxed?
How are segregated funds taxed?
Income tax rules governing segregated funds are set out in section
138.1 of the Income Tax Act (“the Act”).
• A segregated fund is deemed to be a trust for tax purposes.
• The investment policy of each fund is to allocate its income and
capital gains and losses realized in the year to policyholders, so that
no income tax will be payable by the fund (after taking into account
any applicable losses of the fund). The allocation is in proportion to
the number of notional fund units held by every policyholder on
December 31st of each year. And allocations take into account the
length of time that an investor has been in the segregated fund.
• The policyholder has a cost base of their interest in the policy which
is increased by allocations of income and capital gains and
decreased by capital losses. This means there is no change in Net
Asset Value before or after the allocation (the income is in effect
automatically reinvested). The policyholder has the same number of
units, but the value of the units changes.
• Each fund has a December 31 year-end and a trust return (T3) must
be completed.
• A tax of 25% must be withheld on certain income allocated to
nonresidents holding non-registered policies (this rate can be
reduced by treaty).
One of the greatest selling features of segregated funds is the capital
guarantee that is offered. Investors have the assurance that their capital
is protected and will be returned to them after 10 years (maturity
guarantee) or on death (death benefit guarantee) whichever comes
first. This is true, regardless of any drop in value that the investment
might have suffered. Different insurance companies offer different
capital guarantees. Capital or Downside Risk Protection Guarantees
typically range from 75 to 100% of the original capital.
Currently, the taxation of guarantee payouts or top-ups (maturity and
death benefit guarantees) is ambiguous since the Income Tax Act does
not address the treatment of guarantees specifically. The Department
of Finance is in the process of rewriting section 138.1 of the Income Tax
Act with respect to segregated funds.
The following represents Sun Life Financial’s view, based on the current
income tax legislative environment, on how the guarantees should be
treated for income tax purposes. This summary does not include all
possible tax considerations. Clients and advisors should consult their
personal tax advisor about the particular circumstances of every
individual contract.
–1–
Taxation of Segregated Funds continued
FOR NON-REGISTERED CONTRACTS:
• all top-up payments made to the death benefit and maturity guarantees
should be taxed on receipt as capital gains.
• guarantee fees paid by the fund (i.e. segregated fund trust) would be
deductible by the fund against its income.
• guarantee fees paid by policyholders (including payments by means
of redemption of units, i.e. Earnings Enhancement Benefit (EEB))
would be treated the same as acquisition fees which ultimately will
be treated as capital losses (S138.1(6)). We believe the capital loss
would likely be deductible in the year the top-up is realized as a
capital gain or when the client sells out of the contract.
FOR REGISTERED CONTRACTS:
• all payments made to the death benefit and maturity guarantees
should be taxed on receipt as income. The payment would be considered
to form part of the fair market value (FMV) of the segregated fund policy
at the time of death or maturity.
• when a surviving spouse is named as beneficiary, the proceeds
payable on death of the policyholder are taxable to the surviving
spouse as a refund of premiums in an RRSP/RRIF. They can be rolled
into the surviving spouse's RRSP or RRIF and deferred as income until
the year in which it is received; similar rollover provisions are
available to dependant children or grandchildren.
• redemption of notional units to pay for guarantee fee should not
trigger a taxable disposition.
CONCLUSION
The above information is our interpretation of the current Income Tax
Act in light of non-binding opinions released by Canada Customs and
Revenue Agency (CCRA).
We believe that all guarantees top-ups, whatever their nature, should
be treated identically for tax purposes:
• The Basic, Combined and Full guarantees offered by SunWise provide
downside risk protection against loss of premium deposits - i.e. FMV
of policy year deposit is lower than initial deposit at the time of death
or Deposit Maturity.
• The optional EEB pays out an additional benefit at the time of death
provided that the market value of the premium at the time of death is
greater than the initial premium.
We don't believe that CCRA would view the EEB payment as tax-free
death proceeds. Similar to the typical segregated fund guarantee, the
EBB would likely be considered to form part of the policy and as such,
a benefit that the policyholder becomes entitled to receive to which
paragraph 138.1(1)(j) of the Act would apply. This would mean that
payments made to the EEB would be taxed on receipt as capital gains
for non-registered policies and fees paid would be deductible.
In the case of registered policies, the EEB payment would be considered
to form part of the fair market value of the segregated fund policy at the
time of death and would be taxed as income except when a surviving
spouse is named beneficiary. In this instance, the proceeds payable on
death of the policyholder are taxable to the surviving spouse as a refund
of premiums in an RRSP or a designated benefit in a RRIF which can be
rolled into the surviving spouse's RRSP or RRIF and deferred as income
until the year in which it is received. Similar rollover provisions are
available to a dependent child or grandchild.
Tax Treatment of SunWise Elite’s Earnings
Enhancement Benefit: an example
SunWise Elite features the Earnings Enhancement Benefit, which pays
on death, a percentage of the increase in value of the policy over the
sum of net premium deposits. The cost of the benefit is 30 bp per
annum, calculated on the average daily FMV of the assets. This cost is
prorated and deducted each month, from the funds and paid into the
contract from redemption of notional units (see the Information Folder
for more details).
As previously mentioned, there is some uncertainty around the tax
treatment of segregated fund benefits and their cost. The following
represents Sun Life Financial’s view of how the segregated fund should
be treated for income tax purposes.
The following table attempts to show all the possible circumstances
under which the benefit would be paid, and to clarify the tax treatment
in each case. In all cases, we assume a single lump-sum deposit of
$100,000 made at age 60, to a Combined Guarantee fund. The owner
passes away in the 8 years from the date of investment.
–2–
Taxation of Segregated Funds continued
EEB fees: This supplementary Death Benefit is
treated from a taxation perspective much like the
typical downside risk protection guarantees.
Non-Registered Policy
Registered Policy
The 30 bps fee on contract value would be
considered an acquisition fee and deducted as
capital loss.
Redemption of units to pay for the
EEB should not trigger a taxable
disposition.
Redemption of units (proceeds used for
paying the EEB fees) triggers realization of
deferred capital gains or losses.
Example:
first year, annual 10% return
• Annual EEB fees: $330, deductible as a capital
loss at the time the EEB payment is realized as
capital gains or policyholder surrenders the
contract.
• Redemption of units: $30 realized capital gain.
Value of Contract / Benefit at death
before taxes
Value of underlying investment
Initial Deposit
Investment Loss
Current Market Value
Segregated fund benefits
Guarantee value @last reset
Death Benefit
EEB cost
EEB payout
Contract Value before taxes
Value of underlying investment
Initial Deposit
Investment Gain
Current Market Value
Segregated fund benefits
Guarantee value @last reset
Death Benefit
EEB cost (2)
EEB Guarantee Benefit top-up
Contract Value before taxes
Non-Registered Contract (1)
$100,000
($20,000)
$ 80,000
$100,000
$ 20,000
$2,000
$0
$100,000
$100,000
$ 80,000
$180,000
Registered Contract
Capital Loss on Investment
$ 20,000
Top-up = Capital Gain
Capital Loss on Investment
($20,000)
$ 2,000
Residual Capital Loss
Contract Value after taxes
$ 2,000
$ 100,500
Capital Gain on Investment
($ 80,000)
Capital Loss on Investment
Top-Up = Capital Gain
Total Capital Gain
Contract Value after taxes
$ 4,000
($ 32,000)
$ 108,000
$ 185,000
$180,000
$0
$ 32,000
$212,000
–3–
Top-up occurs within registered plan.
It is deemed taxable income when
withdrawn from registered plan.
The EEB benefit would be considered
as part of the fair market value of the
asset held under the registered plan
and taxable as income.
Taxation of Segregated Funds continued
Value of underlying investment
Initial Deposit
Investment Gain
Current Market Value
Segregated fund benefits
Guarantee value @ last reset
Death Benefit
EEB cost (3)
EEB Guarantee Benefit top-up
Contract Value before taxes
$100,000
$ 80,000
$180,000
$220,000
$ 40,000
$ 32,000
$ 252,000
Capital Gain on Investment
Top-Up = Capital Gain
Capital Loss on Investment
Top-Up = Capital Gain
Total Capital Gain
Contract Value after taxes
$ 80,000
$ 40,000
($ 5,000)
$ 32,000
$ 147,000
$ 215,000
Top-up occurs within registered plan.
The top-up is taxable income when
withdrawn from registered plan.
The EEB benefit would be considered
as part of the fair market value of the
asset held under the registered plan
and taxable as income.
(1) Tax Liability: Capital gains inclusion rate 50%, and 50% tax rate.
(2) Cost of the EEB: annual 30 bps on the value of the contract that grows at an avg 8%
(3) Cost of the EEB: annual 30 bps on the value of the contract that grows at an avg 10% with more volatility
(i.e. contract value grows to 220,000 before falling to 180,000)
TAXATION OF NON-REGISTERED PLANS
Segregated funds
We allocate segregated fund income to you annually.
Income net of fund expenses may contain capital gains or capital losses,
Canadian dividends, Canadian interest, foreign income and other
income. CI will send you a tax slip at the end of each year showing each
type of income separately. You must report these amounts on your
income tax return.
Income allocation will increase the adjusted cost base of your segregated
fund holding to ensure these amounts are not taxed again on withdrawal.
If the fund has a capital loss, the loss allocation will decrease the
adjusted cost base of your segregated fund holding.
If you’ve withdrawn or exchanged units from a segregated fund, the
withdrawal or exchange will result in either a capital gain or a capital
loss. The capital gain or loss equals the difference between the market
value of the units on the day of the withdrawal or exchange and the
adjusted cost base. The capital gain or loss is combined with the
capital gains or losses that the segregated fund has allocated to you on
the same tax slip.
You must report capital gains or losses on your income tax return.
Changing an underlying mutual fund may result in a gain (or loss) being
realized and allocated to you.
Sun Life Assurance Company of Canada, a member of the Sun Life Financial group of companies, is the sole issuer of the individual variable annuity contract
providing for investment in SunWise Elite segregated funds. A description of the key features of the applicable individual variable annuity contract is contained
in the Information Folder. SUBJECT TO ANY APPLICABLE DEATH AND MATURITY GUARANTEES, ANY AMOUNT THAT IS ALLOCATED TO A SEGREGATED
FUND IS INVESTED AT THE RISK OF THE CONTRACT HOLDER AND MAY INCREASE OR DECREASE IN VALUE. ®CI Investments and the CI Investments design
are registered trademarks of CI Investments Inc. ®SunWise is a registered trademark of Sun Life Assurance Company of Canada. 10/09
–4–