Cash Value Accumulation Test (CVAT) & Foreign Life Insurance
Cash Value Accumulation Test (CVAT) & Foreign Life Insurance: In order for a life insurance contract to qualify as life insurance under the Internal Revenue Code, it must meet either the Cash Value Accumulation Test or the guidelines premium/cash value corridor requirements. The first test under 7702 is the CVAT and the more common of the two tests. CVAT applies to foreign life insurance as well. And, since many foreign life insurance policies are ULIP (Unit Linked Insurance Policies) with a significant investment component to it, CVAT compliance and analysis is important for offshore and foreign policy tax and reporting.
Let’s review the Cash Value Accumulation Test (CVAT) under IRC 7702(b).
What is the Cash Value Accumulation Test (CVAT)?
As provided by Internal Revenue Code section IRC 7702(b):
(b) Cash Value Accumulation Test for subsection (a)(1)
(1) In general
A contract meets the cash value accumulation test of this subsection if, by the terms of the contract, the cash surrender value of such contract may not at any time exceed the net single premium which would have to be paid at such time to fund future benefits under the contract.
The key phrases to CVAT are:
- Cash Surrender Value
- Exceed Net Single Premium
In other words to qualify under CVAT, the Cash Surrender Value may not exceed the net single premium. So, if the single premium each year is $10,000, then the cash surrender value of the policy cannot exceed $10,000. If it does, then the policy does not qualify under CVAT.
What is the Cash Surrender Value of an Insurance Policy?
The cash surrender value is the value a person can “surrender” the policy for. The value is going to be significantly lower than the “pay out” or “face value” of the policy.
As provided by 7702(f)(2)(A)
(A) Cash surrender value
The cash surrender value of any contract shall be its cash value determined without regard to any surrender charge, policy
(2) Rules for applying paragraph (1)
Determinations under paragraph (1) shall be made—
(A) on the basis of interest at the greater of an annual effective rate of 4 percent or the rate or rates guaranteed on issuance of the contract,
(B) on the basis of the rules of subparagraph (B)(i) (and, in the case of qualified additional benefits, subparagraph (B)(ii)) of subsection (c)(3), and
(C) by taking into account under subparagraphs (A) and (D) of subsection (e)(1) only current and future death benefits and qualified additional benefits.
(g) Treatment of Contracts which do Not Meet Subsection (a) test (1)
What happens when a contract does not qualify under CVAT?
As provided by the IRS
(A) In general If at any time any contract which is a life insurance contract under the applicable law does not meet the definition of life insurance contract under subsection (a), the income on the contract for any taxable year of the policyholder shall be treated as ordinary income received or accrued by the policyholder during such year.
(B) Income on the contract For purposes of this paragraph, the term “income on the contract” means, with respect to any taxable year of the policyholder, the excess of—
(i) the sum of—
(I) the increase in the net surrender value of the contract during the taxable year, and
(II) the cost of life insurance protection provided under the contract during the taxable year, over
(ii )the premiums paid (as defined in subsection (f)(1)) under the contract during the taxable year.
(C) Contracts which cease to meet definition
If, during any taxable year of the policyholder, a contract which is a life insurance contract under the applicable law ceases to meet the definition of life insurance contract under subsection (a), the income on the contract for all prior taxable years shall be treated as received or accrued during the taxable year in which such cessation occurs.
What Does this Mean?
Essentially, it means if the policy does not meet the requirements under CVAT, then the difference in values may become taxable. And, if the policy ceases to be insurance, then all prior tax years become taxable in the year the income from the cessation accrued or received.
Foreign Life Insurance & the IRS
In conclusion, when a person has foreign life insurance, there are concerns about whether the policy qualifies under U.S. tax law; is the income taxable; whether the policy qualifies as PFIC — and if it has to be reported on FBAR & FATCA. Using CVAT, if the cash surrender value is too high, then it may not meet the CVAT and will have to try to meet the alternative test.
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