Taxation
of Segregated Funds - Simplified
Author:
Standard Life
So
some of your clients have just purchased a segregated fund contract. Do they
know that technically what they own is a life insurance contract? Specifically
– a variable annuity contract. And they may be wondering, “How
is my contract taxed?”. In the case of a segregated fund contract, or
variable annuity contract, the Income Tax Act deems the contract to be a
trust for the purposes of taxation. At first blush, a segregated fund contract
can appear very similar to a mutual fund, but the application of taxes differ.
Segregated Funds “allocate” income,Mutual Funds “distribute”
income
Segregated
funds “allocate” income, capital gains and capital losses to contractholders.
An allocation does not result in an increase in units and corresponding drop
in price. Allocations will, however, increase or decrease the adjusted cost
base (ACB). Standard Life keeps track of this for your clients. Segregated
funds will flow through both capital gains and losses. This means your clients
can offset any losses against gains to reduce their overall tax bill.
Mutual funds distribute income – this results in additional units or
shares and a corresponding drop in
unit value. Mutual funds can only flow through capital gains. Capital losses
are kept within the fund and
applied against any capital gains before the distribution occurs. So, in
reality, they flow through net capital gains. If there are no current capital
gains to apply the losses against, they can be used in future years.
Why do funds – both mutual and segregated – flow through income
at all? Income should never be
retained in a trust. Intervivos trusts are taxed at the highest personal
tax rates and cannot benefit from
personal tax credits.1
Taxation of registered accounts
Allocation of income is the same for both nonregistered and registered accounts.
However, with
registered plans, your clients are only taxed on monies that become deregistered.2
They would receive a
T4RSP or T4RIF reporting as income any amounts that are withdrawn. Withdrawals
from registered plans are subject to withholding tax.
Foreign content in registered accounts
The Income Tax Act restricts the amount of foreign content that can be held
in registered plans to 30%.
Currently, the foreign content rule does not apply to segregated funds. The
legislation is expected to
change at some point. Once this happens, if your clients hold more than 30%,
based on the ACB of
their fund, not its current value, they will be taxed on any excess amount.
Earnings are taxable in non-registered plans
Income and realized gains, whether allocated to your clients through a segregated
fund or distributed to
your clients through additional units in a mutual fund are taxable in non-registered
accounts.
Taxation of segregated fund allocations
Earnings of a fund can be divided into the following categories: Canadian
dividends, foreign income, other
income and capital gains. The allocation of income including capital losses,
is reported to non-registered
contractholders on a T3 slip – each type of income is identified. Residents
of Québec will receive a Relevé 16 in addition to the T3. When
Canadian dividends are allocated, the dividend tax credit is allocated to
your clients as well.
1 There are two types of trusts. Intervivos trusts and testamentary
trusts. Mutual funds are intervivos trusts and segregated funds are deemed
to be intervivos
trusts for the purpose of taxation. Testamentary trusts are taxed at the
graduated personal levels and can benefit from personal tax credits.
2 Monies moved between registered plans are not subject to tax.
In
the case of a foreign income allocation, the foreign tax paid, if any, would
also be allocated. Your clients
can then claim a foreign tax credit.
Non-resident contractholders3 receive an NR4 indicating both allocations
and non-resident withholding tax, if required. Non-resident withholding tax
is required for income allocations – tax is not required to be withheld
for capital gains allocations.So an NR4 would only be issued if, as non-resident
contractholders, your clients received an income allocation.
Example: Calculation of an ACB
Carol made a deposit of $10,000 in a Standard Life Ideal Segregated Fund
Contract at the beginning of
the year. The unit value was $10.00, so she had 1,000 units. By year-end
the unit value had risen to
$12.00 – this included $0.75 of realized capital gains and $0.25 of
Canadian dividends. The remaining
gain is unrealized.
Carol will be issued a T3 at year-end allocating a capital gain of $750.00
and a Canadian dividend
amount of $250.00. Her T3 would also indicate a federal dividend tax credit
of $41.70 ($250 X 125%
X 13.33%).
The fund unit value remains at $12.00. And she continues to have 1000 units.
Carol’s new ACB is
$11.00 ($10.00 initial unit value + $0.75 of capital gains + $0.25 of Canadian
dividend income). The
increase in Carol’s ACB will be reported on her statement. Standard
Life keeps track of her ACB to
help ensure any amounts she has previously been allocated are not taxed again
- if she withdraws any
funds from her contract.
Time-weighted
allocations
Segregated funds allocate income on a time-weighted basis. If your clients
became investors in a segregated fund contract during the year, they will
receive an allocation based only on the time they were in the fund. And the
allocation is prorated – so they’re only responsible for the proportion
of the fund attributed to them. The time-weighted method estimates the amount
of income the fund earned while your clients participated in the fund and
allocates it proportionately.
Mutual funds don’t use this method. As mutual fund investors your clients
would receive their share of the
distribution – prorated based on the units they own - on the distribution
day, regardless of how long they
had owned the fund.
Income is allocated first to investors who have left the fund
Investors who have left the fund (transfers, withdrawals or redemptions)
are allocated their proportion of any income first. This seems fair –
and it reduces the income left to be allocated. Remaining capital gains or
losses are allocated to contractholders at year-end – and remember –
this allocation is on a time-weighted basis – so it takes into account
when during the year your clients became investors.
Segregated funds avoid double taxation through elections
One potential problem with investment funds is the correct allocation of
capital gains. When investors
withdraw any of their investments, their share of the unrealized gains or
losses remain within the fund,
which could cause a double taxation when the securities are ultimately sold.
In the case of Segregated
Funds there is an election available to the fund to solve the problem. The
portion of unrealized gains or
losses attributable to redemptions is eligible for an election whereby the
cost of assets remaining in the
fund is adjusted. This has the effect of avoiding double taxation which could
otherwise occur.
3 Non-residents cannot purchase a segregated fund contract,
but if a Canadian resident becomes a non-resident after the purchase of the
contract, it will remain in force.
Sales
charges do not form part of your cost or disposition value
Segregated fund sales charges are not included in calculating the capital
gain or loss – they are reported
separately on the T3 as a capital loss. The separately reported loss would
occur when you sell your
segregated fund – either a deferred sales charge or pro-rated front
– load charge4. With a mutual fund,
sales charges are subtracted directly from your purchase price (in the case
of a front-load charge) or
redemption price (in the case of a deferred sales charge).
Example: Taxation of funds with a deferred sales charge
Rob invested $15,000 in a Standard Life Ideal Segregated Funds Contract.
Four years later his contract is worth $20,000 and he decides to surrender
his profit of $5,000. Let’s assume he had previously been allocated
$2,000 of income and capital gains – this increased his ACB to $17,000
($15,000 + $2,000).
When Rob surrenders $5,000 from the contract a surrender charge of 1% applies
– so in actual fact he
receives $4,962.50. The ACB that applies to his surrender is $4,250 ($17,000
X $5,000 / $20,000). This means he has a capital gain of $750 ($5,000 –
4,250) – this is reported on his T3 slip. In addition,
Standard Life would issue a separate capital loss to Rob of $37.505 the applicable
deferred sales charge.
The result is that Rob would have a capital gain of $750 and a capital loss
of $37.50, resulting in a net
capital gain of $712.50 – half of which is taxable.
Taxation of guarantees
Now, you may be aware that life insurance policies, purchased for protection,
pay out death benefits tax
free. Segregated fund contracts, as variable life annuities are not considered
exempt life insurance
policies. Any death benefit payable remains taxable. And the payment of a
guarantee, whether death or
maturity is taxed as a capital gain – so only 50% of the amount is included
as income.
A note on resets: Standard Life believes that resets available in
some segregated funds bring undo risk and require prohibitive fee increases
to cover the potential losses. We note, however, that because there is no
disposition, resets do not result in a taxable event – the contractholder
is simply resetting the guarantee.
Example: Taxation of a maturity guarantee benefit
Gale invested $10,000 in a Standard Life Ideal Segregated Fund Contract in
2000 and assigned a
maturity of 15 years to her contract. During the 15 years she has had allocations
of capital gains and
losses resulting in an ACB of $6,000. In 2015 the value of her contract was
only $5,000. In this case
Standard life would top up the value of her contract an additional $2,500
to bring the value to the 75%
guarantee of $7,500 ($10,000 X 75% - $5,000). The top up of her contract
will have no effect on her ACB
– the increase would become taxable as a capital gain once the funds
are withdrawn or transferred.
Example: Taxation of a death benefit guarantee
In 2000, James made a deposit of $50,000 into a segregated fund contract.
If he were to pass away,
let’s say 2 years later, when the contract was worth only $40,000, James
would have a deemed disposition. The payout to his designated beneficiary,
his wife Noreen, would be the full value of the $50,0006 guaranteed through
the death benefit of the contract.
Assuming
the plan was non-registered, when James’ terminal tax return is filed,
he would have to report
the capital gain of $10,000 – the death benefit. But he would also have
an offsetting capital loss of
$10,000 – either allocated to him in previous years, allocated on his
final disposition, or a combination
of both.
On a net basis, this capital event could be considered a non-taxable event.
4 Pro-rated based on the proportion
of the fund redeemed (i.e., a partial withdrawal of funds).
5 Deposit Equivalent Amount = Amount to be surrendered X Total net deposits/Total
book value as of the surrender date
$5,000 X $15,000/$20,000 = $3,750. Applicable deferred sales charge = $ 3,750
X 1% = $ 37.50.
6 Assume no additional deposits or withdrawals have been made.
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Ivon T. Hughes, The Hughes Trustco Group Ltd.
Online Insurance Broker - Get a FREE Quote TODAY!
Tel: (514) 842-9001 Email: [email protected]
Web: http://www.trustco.ca
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