How to report disposition of Canadian Life Insurance policy?

[Rick1725]

My clients are US Citizens. They surrendered a Life Insurance policy to Sun Life (a Canadian company). They received Canadian financial documents and what looks like tax forms. The proceeds were $15553. The Cost Basis is reported as $3885. It looks like Canadian tax was withheld in the amount of $2590. HELP! Do we have to file a Canadian tax return? I've never done that. I assume it's necessary to report the transaction on their US return? if so, how? Is there any recourse for the amount withheld? Thank you for any guidance.

[itonewbie · Accepted solution]

Disposition of life insurance policies is governed by §72.  You may not, however, rely on the cost basis furnished for Canadian tax purposes and use that for US tax reporting.  For US tax purposes, you'd need to consider not only premiums paid over the years but also amount borrowed from the policy, cost of benefit for insurance coverage, as well as cash surrender value.

Premiums paid to date reduced by the cost of benefits for insurance coverage would be the adjusted cost basis.  The difference between the sales proceed and adjusted cost basis is the gain, which may not be treated as capital gain entirely because the IRS' position is that surrender of such policy, to the extent there is a surrender value, would only produce ordinary gain as policy surrender is not a capital gain transaction.  The result is that the portion that would otherwise be deemed ordinary income would remain as such and the balance may be treated as capital gain.

In terms of double taxation, you should be able to claim a credit on the US return for taxes paid to Canada.  But you should refer to the US-Canada income tax treaty, depending on where your client reside, and determine whether there is a provision for this type of income, how the treaty assigns taxing right, as well as how and whether the saving clause would apply.

There are more you'd need to worry about because foreign life insurance policy is a mine field for US persons.  You should review whether F.720 was filed each year to report the foreign insurance and the excise tax paid.  Many of these foreign life insurance policy, especially whole life, may include an investment component that may trigger PFIC reporting and failure to report the related earnings/appreciation, which could affect cost basis, could place your client in a punitive tax regime.  Lastly, foreign insurance policies with cash value are subject to both FBAR and FATCA reporting.- question is whether your client had filed these correctly, where required, or at all.

[Rick1725]

I appreciate your thorough response, but honestly, I don't know what you're saying. Does anyone have a more concise explanation. Where do I report to "income"? Sch B or D or Line 21 of Form 1040? And how do I claim credit for Canadian taxes withheld? Do we have to file a Canadian return? Thank you.

[itonewbie]

If you don't understand, my suggestion would be for you to research the issues I've brought up.  Otherwise, you risk exposing your client to various incompliance penalties that could be severe, not to mention your own liability.

[Rick1725]

I agree. Thank you.

[itonewbie]

NP. Good luck.

[nmr12354]

I have the same issue and I took a more balanced view. I claimed the increase in the policy as interest on the federal return and a credit for the Canadian tax on Form 1116 Foreign Tax Credit. I did not get the full foreign tax credit that was withheld. I explained how I calculated the amounts (Exchange rates )  in a statement on the return. I am now researching how to file the Canadian tax return, to determine if any funds withheld by Sun Life are due my client.  If we receive any funds back from Canada, I will amend the federal return. 

[Ambridge]

Wondering if you solved the issue of filing a CRA form to report surrender of life insurance.  Thank you.