Cross Border Insurance United States Compliance

What is Section 7702?

• §7702 and §7702A of the U.S. Internal Revenue Code defines what the federal government considers to be a legitimate life insurance contract and determines how such contracts are to be taxed.

• Life insurance – A “non-MEC” contract—one that fulfills all the requirements of both §7702 and §7702A—receives all the traditional tax benefits of life insurance.
• MEC – A modified endowment contract (MEC) meets the requirements of §7702, but not §7702A. Gain in a MEC is still shielded from taxation as long as it’s realized through death, but distributions are subject to LIFO taxation and may incur an excise penalty.
• Not insurance – A policy that doesn’t meet the requirements of §7702 isn’t life insurance at all for federal tax purposes.

When to get Cross Border testing?

• U.S. citizen living in Canada with a U.S. issued policy - US citizens are subject to US tax rules, no matter their country of residence. 
• U.S. citizen living in Canada with a Canadian issued policy

7702 Compliance

The Internal Revenue Code, United States, provides criteria in 7702 for a life insurance policy to be considered a “life insurance contract”. The policy must pass either the Cash Value Accumulation Test (CVAT), or the Guideline Premium Test (GPT). 

The Cash Value Accumulation Test, defined in 7702(b), is comprised of three elements:

Net Single Premium - The NSP is the premium needed at any time to fund the contract’s future benefits at that time. The NSP represents the maximum cash surrender value permissible in a qualifying contract. 

Cash Surrender Value - Once the NSP is computed, it is compared to the cash surrender value (CSV) of the contract to determine whether the CVAT requirements are met. The CSV must always be less than or equal to the NSP. 7702(f)(2) defines the cash surrender value and net cash surrender value as:

• The cash surrender value of any contract shall be its cash value determined without regard to any surrender charge, policy loan, or reasonable termination dividends
•  The net surrender value of any contract shall be the contract’s cash value determined with regard to surrender charges but without regard to any policy loan. 

Terms of the contract - The third element of the CVAT is that compliance must be guaranteed by the terms of the contract. That is, one should be able to read the contract at issuance and know whether the requirement is satisfied. This is a strict condition of the CVAT, under 7702(b)(1). 

The Guideline Premium Test, defined in 7702(c) is comprised of two elements:

Maximum Premium - The sum of premiums paid under the life insurance policy does not at any time exceed the greater of the “guideline single premium” and the sum of “guideline level premiums” to such time (“guideline premium requirements”); and

Cash Value Corridor

The death benefit of the life insurance policy is not at any time less than a specified percentage of the cash surrender value where this specified percentage is 250% up to age 40 grading down to 105% per a schedule at age 75 and remaining at 105% thereafter (“cash value corridor’).

Currency

Fluctuations in the exchange rate between the US and Canadian dollar will result in changes to the death benefit and cash value on a US dollar basis, as the policy is denominated in Canadian dollars. The IRS has not issued any rulings or guidance on policies denominated in a foreign currency. 

It is our opinion that the policy is measured in United States dollars. For the CVAT, it is our interpretation that the calculations and comparison would use the currency exchange rates at the time of the comparison. As the CVAT is based on the ratio between the death benefit and cash value, the changing exchange rates would not impact this test. 

For purposes of the Guideline Premium Test (GPT), it is our interpretation that both the “guideline single premium” and the “guideline level premium” should be determined in United States dollars as of the policy’s issue date. Actual premium payments made in Canadian dollars should be converted to United States dollars using the currency exchange rate in effect on the respective payment dates. With respect to the Cash Value Corridor requirements, we interpret that the comparison should be conducted using the exchange rate prevailing at the time of evaluation.

It is our opinion that changes in the death benefit due to currency fluctuations are not adjustment events under the GPT, as they were not changes that were previously scheduled under the contract that could not be considered earlier because of computational rules. 

For the purposes of 7702A, the changes to the currency result in a change to the death benefit, and these changes are considered material changes, in the case of increases to the death benefit. In the case of decreases, the lowest death benefit, in US dollars, within the 7 pay period is applied.

As only changes to the currency are important, and not the initial exchange rate, all values in this report are in Canadian dollars. 

Choice of Test

The GPT is a retrospective test; it only looks at years of the policy that have already occurred. Future years can be examined for possible future compliance, but policy failure does not occur until the actual year of failure. This is in contrast to the CVAT, which can only be passed if the policy guarantees compliance for all policy years, including future years. 

The CVAT generally allows more cash value than the GPT. It also helps to avoid currency fluctuations. Whole life policies issued in the United States are meant to use the CVAT, but there is no requirement that a policy use a specified test.

Most Canadian participating policies do not have contract wording that can guarantee compliance with the CVAT. For such policies the ‘terms of the contract’ do not allow the use of the Cash Value Accumulation Test, nor would provincial law apply to allow an exemption to this provision.

Non-participating, term policies, and some participating policies, do have the contract wording required to use the CVAT. All other policies would use the GPT. 

Consequences of Failure of 7702

Once a policy has failed 7702, it will forever be a failed policy, even if future values would be considered compliant. There are two primary tax results if a policy is found to not be a life insurance policy:

Annual taxation of investment gains in the policy

• This requires an annual calculation of the investment gain and cost basis of the policy, to determine the taxable income. This must then be reported on the US tax return if the policy owner is a US taxpayer. 
• In the year that the policy fails 7702, all past years of the policy, during which the owner was a US taxpayer, are also reportable as income.

Taxation of the portion of the death benefit, equal to the cash value prior to death. The amount of death benefit in excess of the cash value is still paid without tax, as would be the case for a policy that passes 7702. Effectively, the cash value at death is taxable income. To the extent income from prior years has been reported, increasing the cost basis of the policy, this taxation at death serves to capture income during the final year of the policy. 

If prior income has not been reported, as may the case for a non-US taxpayer owner, with a US taxpayer beneficiary, then the taxation of the death benefit would capture the income of all prior years. 

Consequences of Failure of 7702A

A policy that passes 7702, but fails 7702A, is a Modified Endowment Contract (MEC). Once a policy has failed 7702A, it will forever be a MEC, even if future values would be considered compliant. A policy that is a MEC is not subject to annual taxation but faces additional taxation on policy distributions. Namely, any withdrawals from the policy must initially remove gains, rather than non-taxable cost basis first, and withdrawals or loans prior to age 59.5 will be face a 10% penalty.

A policy becoming a MEC in future years does not result in MEC status for all prior years. Policy withdrawals up to 2 years prior to MEC status could be impacted. 

Overview of §7702A

Life insurance receives more favorable tax treatment than annuities. §7702A’s intention is to deny preferential treatment of living benefits on contracts whose early funding is deemed excessive, by defining them as MECs and exposing them to taxation under §72(e)(10), (e)(11), and (v). A life insurance policy becomes a MEC if premiums are paid at a rate more rapid than one seven-pay premium for each of the first seven years. Certain changes cause the policy to be treated as a new contract with an adjusted premium limitation for a new seven-year period.

Complex rules prescribe the §7702A treatment of other contract changes. Into every CVAT contract §7702A embeds a deemed contract. Its deemed cash value (DCV) accumulates like the actual cash value, but under prescribed assumptions. A premium is “necessary” to the extent it doesn’t cause the DCV to exceed the net single premium (NSP) that defines the CVAT corridor. Any further payment (which would cause the DCV to enter the corridor) is “unnecessary” premium. A “material change” occurs, e.g., when benefits increase for any reason (even if due solely to the corridor or to option B), but its recognition may be deferred until unnecessary premium has been paid. Notionally, when that happens, the cash value buys a paid-up policy, and we issue a new contract for the current death benefit minus the paid-up amount. The new contract is subject to a new seven-year premium limit. We don’t actually issue new policies; we just perform §7702A calculations as though we had. 

MEC testing

The choice of §7702 test affects MEC testing under §7702A. The latter section inherits definitions and calculation rules from the former; they ought to be consistent for each definitional test. 

MEC testing can be simpler for GPT than for CVAT contracts. It is advantageous to make the necessary-premium and guideline-premium limits identical so that the 

Calculate the seven-pay premium as  7Px × DB.

Canadian policies that meet the exempt test rules would also pass the 7-pay rule. 

Cash values and benefits

Cash surrender value (CSV) for all §7702 and §7702A purposes is the amount payable on full surrender, treating surrender charges and policy loans as though they did not exist. It equals account value (whether loaned or unloaned) plus any extra amounts payable on surrender other than dividend accumulations or reasonable termination dividends.

Death benefit is the amount payable by reason of death. To satisfy the §7702 definition of life insurance, it must never be less than a corridor factor times the CSV. The GPT corridor factors are given in the statute. The CVAT corridor factors are the reciprocal of the sum of the NSP.

Increasing benefits can be taken into account prospectively only if they are specified in the contract itself, and then only to the extent they do not increase the NAAR. Increases not specified in the contract are always ignored. It makes no difference that such increases follow a specific pattern specified in advance, as in a policy illustration, because such increases are not guaranteed.

Increasing benefits specified in the contract that do increase the NAAR must be taken into account as they occur. 

For Canadian participating policies, this means that increases shown in illustrations are not taken into account at the time of the test. The illustration may only be used to show that a policy would or would not, remain compliant, if it performed as illustrated, when the calculation was applied in future years. Under the Guideline premium test, the increased coverage is only considered on the anniversary that the increase occurs. This results in less cash value room under the policy. Under the CVAT test, the increase is assumed to have occurred at the start of the policy, resulting in more cash value room.