Principal Issues: Where, under the terms of a segregated fund policy, the insurer allocates a segregated fund's income based on the concept of time-weighted units and the policyholder dies in the year, would the income allocated to the deceased policyholder for the year of death (in respect of the segregated fund’s income for the period up to the date of death of the policyholder) be treated as a right or thing under subsection 70(2)?
Position: No. Rather, the income is to be included in computing the deceased policyholder’s income for the year of death.
Reasons: It is our understanding that where income of a segregated fund is allocated to a policyholder under a segregated fund policy, the policyholder does not obtain a right to an actual distribution out of the segregated fund. As the policyholder to whom a segregated fund income is allocated has no corresponding right to receive an amount as a result of the allocation, it cannot be said that such a policyholder had a right or thing at the time of death with respect to such income.
FINANCIAL STRATEGIES AND FINANCIAL INSTRUMENTS ROUNDTABLE, 7 OCTOBER 2021
2021 APFF CONFERENCE
Question 10
Segregated Funds, Death of an Individual and the Concept of Rights or Property
Segregated funds are acquired under the terms of a life insurance policy (more specifically, a variable annuity contract from a legal perspective) where the policyholder is often also named as the person whose life is insured (often referred to as the “annuitant”). Segregated fund policyholders are allocated notional units based on the amount invested in the segregated fund policy and the unit value at the time of investment. The net asset value of the notional segregated fund units fluctuates with the FMV of the assets and liabilities of the fund.
Consider the following example. An individual owns a segregated fund policy in a non-registered account with a life insurance company. The individual is the annuitant under the policy and the individual’s spouse is the successor annuitant, so the policy does not terminate on the death of the individual if the individual’s spouse is still alive at that time. The individual’s spouse is also named in the policy as a subrogated policyholder within the meaning of C.C.Q (footnote 1) Article 2445. The segregated fund policy was acquired on January 3 of the calendar year. The individual dies on December 1 of the same calendar year and the individual’s spouse becomes the owner in place of the deceased individual. At the very end of the calendar year, the life insurance company allocates the income (interest, dividends, capital gains, etc.) from the segregated fund to the policyholders based on the number of days in that calendar year that a policyholder held notional units of the segregated fund. Allocation based on the number of days held in the year is one of the two main methods of calculating income allocations used in the industry.
Question to the CRA
Can the CRA confirm that income allocations not yet received by the taxpayer as of the date of death and appearing on the T3 slips (footnote 2) (covering 11 months in this example) will constitute “rights or things” of the deceased? If not, who should be taxed on this income (the deceased individual, the individual’s estate or the individual’s spouse)?
CRA Response
Where a taxpayer had, at the date of death, rights or things, the amount of which when realized or disposed of would have been included in computing the taxpayer’s income, subsection 70(2) of the Income Tax Act (footnote 3) provides that the value of those rights or things (other than any capital property, amounts included in subsection 70(1), or property referred to in subsection 70(3.1)) at the date of death is to be added in computing the taxpayer's income for the year of death.
However, the taxpayer's legal representative may elect under subsection 70(2) to file a separate income tax return including the value of the deceased's rights or things and pay the corresponding tax for the taxation year in which the taxpayer died, as if the taxpayer were another person.
Generally, a right to receive an amount may be considered to be a right or thing of an individual within the meaning of subsection 70(2). For this to be the case, the individual would have to be legally entitled to receive the amount at the time of the individual’s death (the right would have to exist) and the value of that right would have to be determinable at that time.
Subsection 248(1) provides that, for the purposes of the Income Tax Act, the term "life insurance policy" has the meaning assigned by subsection 138(12). Under the definition of that term in subsection 138(12), a life insurance policy includes an annuity contract and a contract all or any part of the insurer’s reserves for which vary in amount depending on the fair market value of a specified group of assets (such specified group of assets being defined as a "segregated fund" in subsection 138.1(1)). Thus, for purposes of the Income Tax Act, a segregated fund policy is a life insurance policy to which the provisions of section 138.1 apply.
Paragraphs 138.1(1)(a) and 138.1(1)(b) deem a trust (a "related segregated fund trust") to be established, generally, on the day that the segregated fund is created, and the property of the segregated fund and any income that has accrued on that property is deemed to be the property and income of the related segregated fund trust. Paragraph 138.1(1)(e) deems the segregated fund policyholder to have an interest in the related segregated fund trust. That interest is capital property to the policyholder, taking into account subparagraph 39(1)(a)(iii). By virtue of paragraph 138.1(1)(f), the taxable income of the related segregated fund trust is deemed for the purposes of subsections 104(6), (13) and (24) to be an amount that has become payable in the year to the beneficiaries under the segregated fund trust and the amount therefor in respect of any particular beneficiary is equal to the amount determined by reference to the terms and conditions of the segregated fund policy. In addition, by virtue of subsection 138.1(3), the capital gains and losses of the segregated fund trust from the disposition of any property in the segregated fund are deemed to be capital gains and losses of the beneficiaries (holders) of the related segregated fund trust. The terms and conditions of the related segregated fund policy will generally determine the method and timing of allocations of income and capital gains or losses.
We understand that, regardless of the method of income allocation used by the insurer, no amount is actually paid or payable to a related segregated fund policyholder in respect of income allocations made by the insurer. Those allocations are relevant for tax purposes only, given the rule in paragraph 138.1(1)(f) and the application of subsections 104(6), 104(13) and 104(24). However, they do not create any right to receive an amount to the policyholders. The same applies to capital gains deemed to be the earnings of a related segregated fund policyholder by virtue of subsection 138.1(3).
Consequently, income and capital gains allocated to a related segregated fund policyholder in accordance with the terms of the policy and reported on a T3 slip filed in the policyholder's name for the year of death are not rights or things for the purposes of subsection 70(2), even though those allocations are in respect of related segregated fund income for the period prior to the policyholder's death.
Because of the rule in paragraph 138.1(1)(f), those income allocations are required to be included in computing the deceased holder's income for the year of death under subsection 104(13) and paragraph 12(1)(m). Similarly, the taxable portion of capital gains deemed to be those of the deceased holder pursuant to subsection 138.1(3) must be taken into account in computing the deceased holder's income for the year of death under section 3.
Mélanie Beaulieu
(343) 543-2154
October 7, 2021
2021-089610
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 CQLR (“CCQ”).
2 Canada Revenue Agency, T3 "Statement of Trust Income Allocations and Designations (slip)".
3 R.S.C. 1985, c. 1 (5th Supp.) ("I.T.A.").