March 13, 2020
U.S. Tax Treatment of Foreign
Life Insurance Policies | PFIC | Excise Tax
The U.S. tax code contains wonderful tax benefits for U.S. (domestic) life insurance companies, and the owners of their life insurance policies. However, for U.S. citizens and U.S. residents to obtain those tax benefits with respect to a foreign life insurance policy, the foreign policy must qualify as a “life insurance policy” for U.S. income tax purposes under section 7702 of the U.S. Internal Revenue Code. If the foreign policy does not qualify under section 7702, the U.S. owner of the policy may owe U.S. tax annually on the income buildup inside the policy.
The U.S. rules that determine what qualifies as a life insurance policy for U.S. tax purposes are quite rigorous, so it generally requires an actuarial and/or legal analysis to make a determination. It is likely that many, perhaps most, foreign life insurance policies do not constitute life insurance policies for U.S. income tax purposes. The cost of evaluating whether any specific policy qualifies under U.S. tax law may be sufficiently high that it encourages some individuals to simply assume their foreign policy does not qualify under U.S. tax law.
Some Considerations With Respect to Foreign Life Insurance Policies
The foreign insurance policy must be analyzed from the following perspectives, among others:
- If the policy is considered a life insurance contract under the “applicable law”. In general, “applicable law” refers to the foreign law that governs the issuance of the contract.1
- If it qualifies under section 7702 as a life insurance contract for U.S. income tax purposes,
- The U.S income tax and estate tax consequences of a non-compliant policy,
- If the U.S. owner of the contract is treated as owning a “passive foreign investment company” (PFIC) for U.S. income tax purposes, and
- If there is any U.S. excise tax payable on the insurance premiums.
U.S. INCOME TAXATION OF NON-COMPLIANT FOREIGN POLICIES
If the foreign insurance policy is not an insurance policy under the applicable law, or if it is an insurance policy under the applicable law but does not qualify as an insurance policy under the rules of section 7702, the U.S. owner must generally report the “income on the contract” annually on his/her U.S income tax return, as ordinary income.2
Income on the Contract
The annual income on the contract is the excess of:3
- The sum of the increase in the net surrender value during the year, plus the “cost of life insurance protection” provided during the year, over
- The “premiums paid”4 during the year.
Cost of Life Insurance Protection
The cost of life insurance protection is the lesser of:5
- The cost of life insurance on the life of the insured as determined on the basis of uniform premiums (computed on the basis of 5-year age brackets) prescribed by IRS regulations, or
- The mortality charge, if any, stated in the contract.
In the case of a non-compliant policy, all the prior accrued income on the contract for all prior taxable years, (at least those subsequent to becoming a U.S. person), will be treated as received or accrued during the taxable year in which the noncompliance occurs.6
TREATMENT OF DEATH PROCEEDS FROM NON-COMPLIANT POLICY
If any contract which is a life insurance contract under the applicable law does not meet the definition of life insurance contract under section 7702, the excess of the amount paid by the reason of the death of the insured over the net surrender value of the contract shall be deemed to be paid under a life insurance contract for purposes of section 101.7 (In other words, the normal rules for life insurance proceeds will apply).
On the other hand, if the policy is not a life insurance policy under applicable law, or if the entity issuing the policy is otherwise treated as a “passive foreign investment company” (PFIC) under U.S. tax law, the proceeds on death may be taxed as if it were a PFIC. (Please see below).
IS YOUR FOREIGN LIFE INSURANCE POLICY A PFIC?
It is important for a U.S. citizen or U.S. resident who owns a foreign life insurance policy to know if his/her ownership interest in the policy is treated under U.S. tax law as being an ownership interest in the insurance company itself. If so, the owner may be treated as owning a PFIC. The ownership of a PFIC by a U.S. individual may result in adverse current annual U.S. income tax consequences, as well as adverse U.S. income tax consequences on the death of the owner. For example, any actual or deemed disposition of a PFIC during lifetime, possibly including relinquishing U.S. citizenship or U.S. residency, gifting the policy, or even pledging the policy for a loan, may result in adverse U.S. income taxation under the excess distribution regime.8 Further, the death of the policy owner may also trigger a deemed disposition and result in adverse U.S. income taxation under the excess distribution regime.9
The owner’s interest in the foreign insurance company will not be treated as a PFIC, if the entity is: 10
- A “qualifying insurance corporation”, and
- It derives its income in the active conduct of an insurance business.
Qualifying Insurance Corporation
The term “qualifying insurance corporation” (QIC) means, with respect to any taxable year, a foreign corporation,
- which would be subject to tax under subchapter L (the rules for taxation of insurance companies) if such corporation were a domestic corporation, and
- its applicable insurance liabilities constitute more than 25 percent of its total assets,11 or it satisfies the alternative facts and circumstances test.12
Active Conduct of an Insurance Business
The determination of whether a QIC engages in the active conduct of an insurance business is based on all the facts and circumstances. In general, a QIC actively conducts an insurance business only if the officers and employees of the QIC carry out substantial managerial and operational activities.13 A QIC's officers and employees may include the officers and employees of another entity only if the QIC satisfies the control test14 with respect to the officers and employees of the other entity. In determining whether the officers and employees of the QIC carry out substantial managerial and operational activities, however, the activities of independent contractors are disregarded.15
Some foreign insurance companies issue customized, or even “off the shelf”, contracts which may be called wealth insurance contracts, capital insurance contracts, or even life insurance contracts, which an individual uses to own his/her investments. When these contracts are not compliant with section 7702 they are often referred to as “insurance wrappers”. In some, perhaps most, of these cases, it is made clear that the policy is intended mainly for investment (and perhaps tax) purposes, but not primarily for life insurance purposes. Accordingly, any U.S. citizen or U.S. resident who owns such a policy may be subject to annual U.S. income tax on the “income on the contract” described above. Further, if the U.S. citizen or U.S. resident is considered to have an ownership interest in the entity issuing the policy, it appears the ownership interest may constitute a PFIC. Potential adverse U.S. tax consequences of owning a PFIC are mentioned above.
U.S. EXCISE TAX ON FOREIGN LIFE INSURANCE PREMIUMS
A U.S. federal excise tax of 1% is imposed on the premiums paid on a foreign life insurance policy or annuity contract,16 when the owner is a citizen or resident of the U.S.17
The excise tax generally applies to policies issued by a “foreign insurer,” which is defined as “an insurer or reinsurer who is a nonresident alien individual, or a foreign partnership, or a foreign corporation”.18The term does not include a foreign government, or municipal or other corporation exercising the taxing power. Notwithstanding the foregoing, the excise tax does not apply to “any amount which is effectively connected with the conduct of a U.S. trade or business, unless the amount is exempt from section 882(a) tax pursuant to a treaty with the United States.19
Separate Excise Tax on Foreign Casualty Insurance Premiums
Residents of the U.S. are subject to a separate 4% U.S. excise tax on premium payments with respect to foreign casualty insurance.20 (It does not apply to U.S. citizens who are not resident in the U.S.) Casualty insurance is any policy (other than life) or other instrument, by whatever name called, whereby a contract of insurance is made, continued or renewed.21 Hence, it could apply, for example, to insurance on a foreign (non-U.S.) residence, vehicle, boat, etc., owned by a U.S. resident.
It may also apply to an “insurance wrapper” (see above) that does not qualify as life insurance under the “applicable law”.
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1 H.R. Rep. No. 98-432, pt. 2 at 1443
2 IRC §7702(g)(1)(A)
3 IRC §7702(g)(1)(B)
4 IRC §7702(f)(1)
5 IRC §7702(g)(1)(D)
6 IRC §7702(g)(1)(C)
7 IRC §7702(g)(2)
8 IRC 1291(a) and Proposed Treasury Regs.§1.1291-3(b)(2) and §1.1291-3(b)(1)
9 Proposed Treasury Reg. §1.1291-3(b)(1)
10 IRC §1297(b)(2)(B)
11 IRC §1297(f)(1)
12 IRC §1297(f)(2)
13 Prop. Reg. §1.1297-5(c)(3)(i)
14 Prop Reg. §1.1297-5(c)(3)(ii)
15 Prop Reg. §1.1297-5(c)(3)(i)
16 IRC §4371(2)
17 IRC §4372(e)
18 IRC §4372(a)
19 IRC §4373(1)
20 IRC §4371(1) and §4372(d)
21 IRC §4372(b)