Cross Border Insurance - United States - 7702 and 7702A

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

Cash Value Accumulation Test (CVAT) & Foreign Life Insurance: In order for a life insurance contract to qualify as life insurance under the Internal Revenue Code, it must meet either the Cash Value Accumulation Test or the guidelines premium/cash value corridor requirements. The first test under 7702 is the CVAT and the more common of the two tests. CVAT applies to foreign life insurance as well. And, since many foreign life insurance policies are ULIP (Unit Linked Insurance Policies) with a significant investment component to it, CVAT compliance and analysis is important for offshore and foreign policy tax and reporting.

Let’s review the Cash Value Accumulation Test (CVAT) under IRC 7702(b).

As provided by Internal Revenue Code section IRC 7702(b):

(1) In general

A contract meets the cash value accumulation test of this subsection if, by the terms of the contract, the cash surrender value of such contract may not at any time exceed the net single premium which would have to be paid at such time to fund future benefits under the contract.

The key phrases to CVAT are:

• Cash Surrender Value
• Exceed Net Single Premium

In other words to qualify under CVAT, the Cash Surrender Value may not exceed the net single premium. So, if the single premium each year is $10,000, then the cash surrender value of the policy cannot exceed $10,000. If it does, then the policy does not qualify under CVAT.

What happens when a contract does not qualify under CVAT?

Income inclusion
(A) In general If at any time any contract which is a life insurance contract under the applicable law does not meet the definition of life insurance contract under subsection (a), the income on the contract for any taxable year of the policyholder shall be treated as ordinary income received or accrued by the policyholder during such year.
(B) Income on the contract For purposes of this paragraph, the term “income on the contract” means, with respect to any taxable year of the policyholder, the excess of—
(i) the sum of—
(I) the increase in the net surrender value of the contract during the taxable year, and
(II) the cost of life insurance protection provided under the contract during the taxable year, over
(ii )the premiums paid (as defined in subsection (f)(1)) under the contract during the taxable year.
(C) Contracts which cease to meet definition
If, during any taxable year of the policyholder, a contract which is a life insurance contract under the applicable law ceases to meet the definition of life insurance contract under subsection (a), the income on the contract for all prior taxable years shall be treated as received or accrued during the taxable year in which such cessation occurs.

What Does this Mean?

Essentially, it means if the policy does not meet the requirements under CVAT, then the difference in values may become taxable. And, if the policy ceases to be insurance, then all prior tax years become taxable in the year the income from the cessation accrued or received.

In conclusion, when a person has foreign life insurance, there are concerns about whether the policy qualifies under U.S. tax law; is the income taxable; whether the policy qualifies as PFIC — and if it has to be reported on FBAR & FATCA. Using CVAT, if the cash surrender value is too high, then it may not meet the CVAT and will have to try to meet the alternative test.