How are Foreign Life Insurance Policies Taxed?
Foreign Life Insurance Taxation: The tax rules and treatment of foreign life insurance are very complicated. Income generated from a Foreign Life Insurance Policy is taxable in the U.S., and the value of the policy reported to the IRS. When a U.S. person owns a foreign insurance policy, there are several tax issues to consider. Some insurance policies generate dividends, capital gains, interest, and proceeds. If the policy has a surrender value or cash value, and/or is considered a ULIP there may be additional tax issues, such as PFIC.
We will summarize the Foreign Life Insurance Taxation of Policies for U.S. Tax purposes.
What is a Foreign Life Insurance Policy?
Foreign Life Insurance Policies are life insurance policies that are based overseas. They are very popular investment vehicles abroad.
Common examples of foreign life insurance policies, include:
- Prudential or ICICI policy in India
- AIA policy in Singapore
- Part of your Australian Superannuation or Provident Fund
Is it Taxable?
A Foreign life insurance policy has to two components to it: taxation of foreign income and offshore reporting on forms such as the FBAR and Form 8938.
In addition, when the foreign policy is ULIP (unit-linked), then there is a significant investment component, which further complicates the tax rules and may ignite the PFIC (Passive Foreign Investment Company Rules).
Different Types of Insurance Policies
While life Insurance policies do not generally have an investment component, whereas a Unit Linked Life Insurance Policy combines life insurance with an investments component as well. Either policy is reportable on your U.S. Tax Return.
Foreign Life Insurance Policy
A Foreign Life Insurance Policy does not always have an investment component, or earn any income.
Sometimes, it is just a regular term policy, which may or may not have a surrender value or “cash value,” and it pays out at death or disability.
Unit Linked Insurance Plans
As the name implies, the Unit Linked Insurance Plans combine the investment component, with the insurance component (not always life insurance). As with most insurance policies, the “pay-in” is via premiums.
But, unlike pure insurance policies — there is a second “investment component” as well, which is commingled with the investment, to provide an investment component along with the life insurance coverage.
Example of a Unit Linked Insurance Plan
Some common examples of Unit Linked Life Insurance, include:
Friends Life (aka Aviva)
Personal Pension in the UK or UK Offshore, such as Guernsey.
It generally will contain funds and shares, so at the end of the day, this may be considered a PFIC.
These are common life insurance policies, but they are not necessarily linked to an investment per se. There many flavors (linked and non-liked) and while some tend to take the shape more of “Life insurance” with some accrued interest — others are more investment focused linked insurance policies.
India LIC or Prudential
These may or may not have an investment component to it.
They can vary greatly depending on the type of policy.
Common examples of foreign life insurance policy income, includes:
- Capital Gains
(General) Foreign Life Insurance Policy Tax Rules
With a foreign life insurance policy, there is less room for tax-deferral. In other words, the Internal Revenue Service requires insurance policy holders to pay tax on the income growth and accruals — even if the income is not distributed (subject to PFIC rules).
The timing and rate of tax will vary based on the category of income, type of foreign life insurance policy and whether PFIC issues are involved (common when the policy is “unit-linked”).
IRS Tax on Foreign Life Insurance Income
When it comes to foreign life insurance proceeds, it is important to distinguish between a return of basis and proceeds. When a person pays a life insurance premium, and the premium is returned to the investor — that is not taxable. Why? because it is not earned income. Rather, the post-tax invested money is simply returned to the investor.
Conversely, if the foreign life insurance policy pays or accrues income, then the income is taxable — since those are “gains” on the investment. Whether the income is taxable now or later is dependent on the PFIC (Passive Foreign Investment Company) status of the foreign life insurance policy.
Here are the basics summarized for you:
Payments & Investments into the Policy
At the most basic level, the money invested into the policy used to pay the premiums is not taxed when it is distributed.
While the income generated from the foreign life insurance policy is taxable, the amount invested into the policy, or policy payments made on the policy are not taxable when distributed back out form the policy.
This is because the payment back of the policy payments or investments is merely a “return of basis.”
When the investment into the policy results in the foreign life insurance policy generating income, the income is reported and taxed. This is similar to income earned from a bank account (interest); income earned from a dividend, or income earned from capital gains.
Reporting the Policy
In addition to U.S. tax requirements for life insurance proceeds, interest and dividends, there are also numerous informational reporting required. Some common foreign life insurance policy reporting forms.
Common types of income generated by a foreign life insurance policy, include:
Foreign Life Insurance Dividend payments are generally taxable as foreign passive income.
Foreign Life Insurance Interest payments are generally taxable as foreign passive income.
Foreign Life Insurance Capital Gains payments are generally taxable as foreign passive income.
Some Foreign Life Insurance Policies earn interest or dividend equivalents, which are referred to as“bonus” payments. The bonus is taxable as foreign passive income.
Surrender Value “Cash Out”
A Surrender Value is generally defined as what price the insurance company will pay the policyholder if there is a voluntary termination or other cancellation of the policy before it becomes due.
Depending on how much the surrender value is vs the amount of premiums will impact if the cash-out is taxed, or just considered a return of basis.
Golding & Golding: About Our International Tax Law Firm
Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure and foreign life insurance taxation.
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