Every now and then we get a question from a client that results in some head scratching. Recently we were asked about the use of a joint prescribed annuity as a tool in an investment portfolio, simple enough. The complexity came from an American spouse. The Canadian husband was the annuitant, and while he is alive the income from the annuity will be taxed in his Canadian hands. Upon his death it will be taxable in his wife’s American hands. Both of them are Canadian residents living in Canada.
This avoids the tax issue of a large portion of interest income early on. We know that prescribed annuities are recognized by the CRA, but how the IRS would treat them was not clear.
With some research, we learned that section 148(2)(b) of the Income Tax Act provides that upon the death of the annuitant, the annuity is passed to the spouse without any deemed disposition, and the surviving spouse becomes responsible for reporting the annuity income in her hands. US citizens are taxed on their income regardless of their country of residence, so the annuity income of the American spouse would have to be reported to the IRS and would be taxable as it is received. If the prescribed annuity exception was not accepted by the IRS, the sudden jump from level taxation could result in the annuity contract being much less favourable in the hands of the American spouse, while also eliminating the desired security of a level income.
The big breakthrough came from Article XVIII of the US-Canada tax treaty; the amount taxed in the US can’t be more that the amount that would be included in income in Canada. This means that the level taxation of prescribed annuity income in Canada would be treated the same way in the US, and there would not be a disparity between the foreign tax credit for taxes paid in Canada and the taxes owed in the US. Problem solved!
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Facts:
Since it is a prescribed annuity, under Canadian domestic tax laws (exception for the prescribed unity is at s. 148(2)(b) of the Income Tax Act), upon the death of the annuitant (the husband) the annuity is passed to the spouse and therefore there will not be any deemed disposition upon death in Canada. The surviving spouse will be responsible for reporting the annuity income as she is receiving year over year.
For US citizens, as they are taxed on their world-wide income, the annuity income will have to be reported in the US and it will be taxable as received. However, pursuant to Article XVIII of the US-Canada tax treaty, the amount taxed in the US can’t be more that the amount that would be included in income in Canada, in addition, the US citizen taxpayer would be eligible for a foreign tax credit in the US relating to the Canadian taxes paid.
In addition, as a US citizen, she might need to report the value of the prescribed annuity account annually on Form 8938 (foreign asset form) and possibly (TD 90-22.1 form).
If the US citizen spouse, upon death of her Canadian husband, decides to cease her Canadian residency and move back to the US, under Article XVIII, pensions and annuities from Canadian sources paid to U.S. residents are subject to tax by Canada, but the tax is limited to 15% of the gross amount (if a periodic pension payment) or of the taxable amount (if an annuity). Therefore, she would be subject to tax in Canada as a non-resident in Canada on the annuity income, but limited to treaty rate of 15%.
Please let me know if you have any other questions.
