Tax Characteristics of Segregated Fund Contracts

The BMO Insurance specialized Advanced Markets Team regularly receives questions regarding individual and corporate solutions for high-net-worth clients. This month, we’re looking at some of the unique tax attributes of segregated funds. Here’s what our resident tax expert had to say.  

A segregated fund contract is a financial asset specifically offered by a life insurance entity. In addition to its insurance component, a segregated fund contract also has an investment component that contains one or more investment funds, also known as segregated funds, seg funds, or guaranteed investment funds (GIFs). While their investment characteristics mean they are often compared to mutual funds, segregated funds have their own unique tax attributes that are important to understand.

A Segregated Fund Contract's “Tax Identity”

Under Canada’s Income Tax Act (ITA), a segregated fund contract is taxed as an inter-vivos trust. Even though a segregated fund is not a legal trust:

• the insurance company that issues the segregated fund is considered to be its trustee, and the segregated fund contract’s owner (also known as the policyholder) is deemed to be its beneficiary;
• because of its status as a deemed trust, a segregated fund’s income is annually allocated to its beneficiaries so that no taxes arise within it; and
• pursuant to ITA ss.138.1(3), a segregated fund is unique in that its capital gains as well as its capital losses can be “flowed-out” to its beneficiaries. Neither mutual fund companies nor mutual fund trusts can do this for their capital losses.

Tax Distinctions Between Segregated Funds Contracts and Life Insurance Policies

While an insurance product, a segregated fund contract has specific tax characteristics that differentiate it from a life insurance policy. For example:

• unlike a life insurance policy, an interest in a segregated fund contract is considered to be capital property, and as such can be considered “eligible property” for the purposes of an ITA ss.85(1) tax-deferred transfer;
• whereas the disposition of an interest in a life insurance policy can result in a policy gain, disposition of an interest in a non-registered segregated fund contract results in a capital gain or loss. Note this means that, for an interest in a corporately-owned contract, a disposition that results in a capital gain will also result in a credit (increase) to the corporation’s Capital Dividend Account (CDA); and
• while there is a general rule prohibiting interest deductions related to the purchase of life insurance, ITA s.20 provides that interest on money borrowed to invest in a non-registered segregated fund contract may be deductible (subject to the normal rules for interest deductibility).

Your advisor can help you understand more about how segregated fund contracts work, as well how they can fit into your investment portfolio.

Disclaimer:
Information contained in this article is general in nature and should not be construed as legal or tax advice. You are encouraged to seek the advice of other professionals such as legal and tax experts. Please consult the appropriate policy contract for details on the terms, conditions, benefits, guarantees, exclusions and limitations. The actual policy issued governs. Each policyholder’s financial circumstances are unique, and they must obtain and rely upon independent tax, accounting, legal and other advice concerning the structure of their insurance, as they deem appropriate for their particular circumstances. BMO Life Assurance Company does not provide any such advice to the policyholder or to the insurance advisor.

Insurer: BMO Life Assurance Company       
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