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

Detailed Explanation - This is for those interested in learning more. 

The information presented is an overview, followed by more detailed commentary on the relevant sections of the Internal Revenue Code §7702 and §7702A. 

For income tax purposes, a life insurance policy will be one of three classes:

• A policy that doesn’t meet  the requirements of §7702 isn’t life insurance at all for federal tax purposes. In practice, such policies aren’t knowingly sold.
• 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.
• A “non-MEC” contract - one  that fulfills all the requirements of both §7702 and §7702A - receives all the traditional tax benefits of life insurance.

Overview of §7702

Life insurance contracts must meet one of two tests prescribed by Internal Revenue Code §7702 in order to qualify for favorable tax treatment in the United States. One is the cash value accumulation test (CVAT); the other is the guideline premium and corridor test (GPT).

Cash Value Accumulation Test (CVAT)

The CVAT has only one requirement: that the death benefit (DB) must never be less than a certain corridor factor times the §7702(f)(2)(A) “cash surrender value” (CSV). The statute defines CSV as account value (AV) ignoring any surrender charge, loan, reasonable termination dividend, or dividend accumulation. The CVAT corridor factor for each attained age is calculated at issue under assumptions prescribed by law, always assuming DBO A (level death benefit). It normally varies by gender, and sometimes by tobacco use and underwriting class.

Guideline Premium Test (GPT)

The GPT has two requirements that must both be met at all times. The first is that the DB must never be less than a certain corridor factor times the §7702(f)(2)(A) CSV. The GPT corridor factors vary only by attained age, and not by gender, tobacco use, or underwriting class. The corridor factors are more liberal than for the CVAT because the GPT also imposes premium limits.

The second GPT requirement limits cumulative premiums at each moment. The limit is the greater of the guideline single premium (GSP) or the cumulative annual guideline level premium (GLP). Both guideline premiums are generally calculated according to actual contract mechanics, using assumptions prescribed by law. The minimum interest assumption is higher for the GSP than for the GLP. Unlike seven-pay premiums used for MEC testing, guideline premiums are loaded for current expense charges. The GLP varies by level or increasing death benefit, but the GSP always assumes level death benefit. Guideline premiums are calculated at issue, and do not automatically change as attained age increases. They do generally change when benefits change.

GPT adjustment method – attained age increment and decrement rule

This is important for Canadian policies, which may increase up to 8% per year.

Under GPT, an increase/decrease in future benefits is treated separately from existing guideline limits. Separate guideline premiums are computed to reflect the increase/decrease. 

Incremental Guideline Single Premiumx+t= GSP(After)x+t  – GSP(Before)x+t

This can be expanded to solve for the new GSP:

GSP(New)x+t = GSP(Old)x+GSP(After)x+t – GSP(Before)x+t

Incremental Guideline Level Premiumx+t= GLP(After)x+t – GLP(Before)x+t

The formula for GLP(new) will parallel this formula:

GSP(New)x+t = GSP(Old)x+GSP(After)x+t – GSP(Before)x+t

Choice of CVAT or GPT

A product can offer a choice of GPT or CVAT, but one test must be chosen for each contract when it is issued. The test chosen generally cannot be changed after issue. Compared to the CVAT, the GPT is generally more conservative at early durations due to a stricter initial premium limit based on 4% interest, but more liberal in later years because of lower corridor factors. The CVAT is the simpler and more flexible §7702 test, but MEC testing can be much simpler for GPT contracts. The GPT is preferred in the high net worth market where the net amount at risk (NAAR) may ultimately exceed available reinsurance.

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. 

Issue, attained, and maturity age

Age means insurance age, nearest (ANB) or last (ALB) birthday as specified by the contract, as long as it is within one year of actual age. For ANB, if two birthdays are equally near, either age may be used.

The issue age is the insurance age on the contract effective date. When a contract is backdated, this produces the correct result because it is the effective date that is backdated. §7702 does not allow artificial age adjustments exceeding one year, such as the setbacks for female or substandard that were common in the past, or the joint equivalent age method that is still sometimes used for survivorship contracts.

The insurance age at the beginning of the policy year defines the attained age, which is used for all off-anniversary changes. If an insured born on 1960-01-01 purchases an ANB contract on 2000-07-02 at insurance age 40, and changes it on 2001-07-01, the day before the first anniversary, then all §7702 calculations for the change use age 40, even though the transaction occurs 41 years and 181 days after birth.

Rates and values are looked up by attained age as defined above for §7702A calculations as well. Thus, when an off-anniversary material change causes the §7702A(c)(3)(A)(i) “contract year” not to coincide with any policy year, the attained age is still the insurance age defined in terms of the effective date given in the contract.

§7702 deems the contract to mature between ages 95 and 100 inclusive. Contracts maturing for a reduced endowment prior to age 95 are deemed to mature at age 95. If the contract does not specify any maturity age, then age 100 is used.

Riders mature when they expire by their terms, or at age 100 if they do not expire.

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.

Interest

§7702 prescribes the interest basis for all §7702 and §7702A calculations as the interest rate actually guaranteed in the contract, or a statutory rate if greater. 

Prior to 2021, the statutory rate is 4% for GLP and 6% for GSP. It is 4% for all CVAT and §7702A calculations.

After 2020 the statutory rate is 2% for GLP and 4% for GSP. It is 2% for all CVAT and §7702A calculations.

The §7702 net rate is determined in two steps. First, the guaranteed interest rate is determined from the contract, and the statutory rate is used instead if it is greater. 

Second, any current asset-based charges specified in the contract are deducted if we wish. The interest rate remains what it is; the net rate that results from subtracting asset-based charges is merely a computational convenience that simplifies the formulas. In fact, the full interest rate (never less than statutory) is credited, and then asset-based charges are subtracted from the account value. Therefore, this adjustment affects only the §7702 guideline premiums and the §7702 DCV, because those quantities reflect expenses. It must not be taken into account when calculating the §7702 CVAT NSP or CVAT corridor factors, or the §7702A NSP or seven-pay premium, because those quantities do not reflect expenses.

Asset based charges can be deducted only if they are specified in the contract itself: charges imposed by separate accounts cannot be deducted unless they are specified in the life insurance contract proper, since any charge not so specified is deemed to be zero. They also must not exceed the charges reasonably expected to be actually imposed. 

At the lower post 2020 rates, it is not necessary to adjust for expenses in order for most Canadian policies to pass these tests. 

It is critical that the result be rounded up if at all, and never rounded down or truncated. The GPT is a bright-line test, and truncation at, say, eight decimal places may have an effect of more than a dollar per thousand at a later duration. Special attention must be paid to the exact method the administration system uses (e.g. beginning of period versus end of period), to be sure that the resulting charge is what will actually be imposed. A §7702(f)(8) waiver granted in one actual case that was pennies over the limit cost tens of thousands of dollars in filing and attorney’s fees.

Thus, an account value load that is deducted from the account value at the beginning of each month, before interest is credited, may be reflected in GPT calculations. 

Mortality

§7702 prescribes the use of reasonable mortality that does not exceed the charges the insurer actually expects to impose, except for the safe harbor that IRS Notice 2006-95 provides. The mortality tables specified in the safe harbor vary by gender (except that unisex rates may be used for females, but only where required by state law) and, if prescribed in the contract, by tobacco use.

For insureds with a substandard table rating, we may compare current mortality reflecting the rating to 100% of safe-harbor mortality, and use the greater of these two values in each year. We may choose to ignore ratings due to foreign residence. We may indeed choose to use 100% of safe-harbor mortality in all cases as a simplification.

Expense charges

Current expense charges that the insurer actually expects to impose are reflected in guideline premiums and the CVAT DCV. Higher guaranteed charges are disregarded. Expense charges are ignored for the CVAT net single premium and for the net single and seven-pay premiums used for MEC testing. However, they are always taken into account for necessary premium calculations. 

Some products pass the actual premium tax through as a load; it’s treated like any other load.