Old Lace, Investments and Insurance can be a complicated unkindness.

The following article demonstrates how innocent investments made from following licensed advisers, can become a complicated tax mess.

To learn more on solving tax problems, please go to [1] www.taxauditsolutions.ca

Dan White
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Ottawa mum on taxing insurers’ fund guarantees

Published On Thu Feb 18 2010

By James Daw Personal Finance Columnist

Nearly 200 funds carrying Canadian life insurer guarantees are worth less than a decade ago.

So thousands of investors may soon be eligible to collect top-up payments to cover a loss of capital.

Yet, after all this time, it remains unresolved how those top-up payments should be taxed, if at all.

There were 199 so-called segregated funds – insurers’ alternative to mutual funds – that were worth less on Jan. 31 than a decade earlier, says researcher David O’Leary of Morningstar Canada.

Investors’ losses, including deductions for annual fees, ranged from an average of 0.1 per cent per year to 19.4 per cent per year in the case of the TransAmerica IMS Information Technology Fund.

The heaviest losses were for fund units purchased shortly before 2000, when the technology stock bubble burst.

TransAmerica used to tell policyholders and agents its top-ups would be tax-free, says Arthur Robson, of Future Planning Insurance Agency Ltd. in Pickering.

Then, a couple of years ago, TransAmerica came around to the expectation of other insurers: That top-ups would be considered a capital gain.

Some insurers have been reporting capital gains to the estates of deceased investors, to the dismay and confusion of heirs.

Consumers think of death benefits from life insurers as being tax-free. A top-up to restore lost capital does not seem like a gain.

Nevertheless, if the top-ups are a capital gain, then investors would have had a loss to offset the gain. So it should be a wash.

The tax question is irrelevant for funds held inside a registered retirement savings plan. Every dollar will eventually be taxed like salary or interest income.

But many other investors have been left in suspense.

“The tax treatment of the top-up is not certain at this time,” Manulife Financial warns investors, urging them to seek tax advice.

It’s not for lack of asking that insurers, and investors, are in the dark. Insurers have asked the Department of Finance to clarify tax legislation. But nothing has happened yet.

“We brought this to finance more than a dozen years ago,” says Ron Sanderson, director of policyholder taxation and pensions at the Canadian Life and Health Insurance Association. “It doesn’t seem to be a high priority with them.”

Yet, stakes are higher after changes in industry offerings and two stock market crashes in a decade.

Sanderson says insurers used to only offer top-up payments at the time of a death or the end of a contract, and only for losses of more than 25 per cent.

It was only after about 1990 that insurers started offering to cover losses after 10 years. Later in the ’90s some guaranteed a 100-per-cent return of capital. More recently some have offered, for an additional fee, to guarantee a minimum annual income.

Sanderson sees why consumers might expect a tax-free payment. They paid extra fees each year for a form of life insurance.

Yet, he says, finance officials led insurers to believe six years ago that they felt the top-ups should be treated as a capital gain. To be safe, some insurers have even reported top-ups as ordinary income, which cannot be offset by a capital loss.

Whether or not insurers report a top-up as a capital gain, all would have reported capital losses as they occurred, Sanderson notes.

Some investors may have reported these losses on earlier tax returns. This should make it relatively easy to use net losses to offset a net gain and avoid taxes on half of any top-up payment.

Regardless, the Canada Revenue Agency should have records after receiving copies of annual T3 tax slips from insurers.

Accountant Nancy Belo Gomes of KPMG points out the Tax Court of Canada agreed with taxpayer Don G. Burleigh in 2004 that a net capital loss need not be reported until it is used to offset a capital gain.

jdaw@thestar.ca