Overview
Segregated funds are a unique investment vehicle that combines features of mutual funds and insurance policies. From a taxation perspective, they are treated as trusts. The insurance company, which is the legal owner of the segregated fund’s assets, does not pay taxes on the income earned by the fund. Instead, the income is allocated to the contract holders, who are responsible for declaring and paying taxes on this income.
Income Allocation
The net income of a segregated fund, which can be in the form of dividends, capital gains, or interest, is deemed to be the income of the contract holder. For non-registered accounts, this income is taxable in the current year. The calculation of the income earned by each contract holder is done through a process called allocation.
How Allocation Works
Income allocation is based on:
- The number of units held by the contract holder
- The proportion of the calendar year during which those units were held
For instance, if a contract is held for six months of the year, it would receive half the per-unit allocations compared to a contract held for the entire year.
Example Calculation
If the total income of the fund (
\(TI\)
) is $100,000, and the number of units held by the contract holder (
\(UH\)
) is 100 units out of a total of 10,000 units, the income allocated to the holder for six months (
\(t\)
) would be calculated as follows:
$$
\text{Income}{\text{holder}} = \frac{TI}{\text{Total Units}} \times UH \times \frac{t}{12}\ \
$$
Where:
-
\(TI = 100,000\)
(total income)
-
\(H = 100\)
(units held)
-
\(\text{Total Units} = 10,000\)
-
\(t = 6 \text{ months}\)
$$
\text{Income}{\text{holder}} = \frac{100,000}{10,000} \times 100 \times \frac{6}{12} = 500 \text{ dollars}\
$$
Impact on Net Asset Values (NAVPS)
Unlike mutual funds, segregated funds do not experience a decline in the net asset value per share (NAVPS) after income is allocated. Instead, the additional income is reflected in the fund’s units, which increases the investor’s adjusted cost base (ACB). This allocated income is reported for tax purposes.
Capital Losses and Gains
A key advantage of segregated funds over mutual funds is the ability to pass both capital losses and gains directly to the contract holder. Mutual funds, on the other hand, must retain capital losses within the fund to offset future gains, and cannot pass these losses directly to unit holders.
Tax Treatment of Guarantees
Payments from the maturity guarantees of a segregated fund contract are taxable. If the proceeds (after commissions) are less than the adjusted cost base (ACB), income tax is payable on the guaranteed amount. However, the contract holder can claim the difference between the market value of the segregated fund and the ACB as a capital loss, resulting in a net tax effect of zero. If the proceeds exceed the ACB, the contract holder is taxed on the capital gain.
Example Calculation
- Proceeds < ACB:
$$
\text{Capital Loss} = \text{ACB} - \text{Market Value}
$$
$$
\text{Net Tax Effect} = 0
$$
- Proceeds > ACB:
$$
\text{Capital Gain} = \text{Proceeds} - \text{ACB}
$$
Tax is payable on the capital gain.
Tax Treatment of Death Benefits
When the annuitant of a segregated fund contract dies, the contract is terminated. The beneficiaries receive the market value of the segregated fund plus any death benefits, tax-free.
- If the contract holder and annuitant are different, the contract continues when the contract holder dies. The deceased owner’s estate is deemed to have disposed of the contract at fair market value, which typically results in a capital gain or loss. The gains or losses are included in the terminal tax return of the deceased owner.
Spousal Transfer
If the contract holder names their spouse as the successor owner, the contract can be transferred to the spouse at its adjusted cost base, deferring capital gains tax until the spouse disposes of the contract. If no successor owner is named, the contract is transferred to the deceased owner’s estate.
Example Scenario
- Contract Holder & Annuitant are the Same: The gain or loss is included in the terminal tax return of the deceased owner for the year of death.
- Different Contract Holder & Annuitant: The contract remains in force, and deemed disposition occurs at the market value.
Frequently Asked Questions (FAQs)
Q: What is income allocation in segregated funds?
A: Income allocation distributes a segregated fund’s net income (dividends, capital gains, interest) to contract holders based on their unit holdings and how long they held those units.
Q: How does a segregated fund’s NAVPS change post-income allocation?
A: Segregated funds’ NAVPS does not decrease after income allocation. Instead, the additional income is allocated to existing units, increasing the adjusted cost base of those units.
Q: What tax implications come with maturity guarantees?
A: Payments from maturity guarantees are taxable. If proceeds are below the ACB, the difference can be claimed as a capital loss. If above, it is taxed as a capital gain.
Q: How are death benefits from segregated funds treated for tax purposes?
A: Beneficiaries receive death benefits tax-free. If the contract holder and annuitant differ, a deemed disposition may trigger capital gains or losses, appearing on the terminal tax return.
Glossary
- Net Asset Value per Share (NAVPS): The total value of a fund’s assets minus its liabilities, divided by the number of units/shares outstanding.
- Adjusted Cost Base (ACB): The original value of an investment, adjusted for dividends, capital gains, or income allocations.
- Deemed Disposition: A tax term where property is considered sold at fair market value, triggering potential capital gains or losses.
- Maturity Guarantees: Guarantees in a segregated fund ensuring a minimum payout at contract maturity.
- Terminal Tax Return: The final tax return filed for a deceased individual.
Key Takeaways
- Segregated funds are taxed like trusts, with income allocated to contract holders.
- Income allocation impacts adjusted cost base and must be reported for taxes.
- Maturity guarantees and death benefits have different tax treatments.
- Special provisions exist for transferring contracts to spouses to defer capital gains liability.
📚✨ Quiz Time! ✨📚
## How are segregated funds taxed?
- [ ] As corporations
- [x] As trusts
- [ ] As individuals
- [ ] As partnerships
> **Explanation:** Segregated funds are taxed as if they were trusts. The insurance company, which is the legal owner of the assets, does not pay taxes on the income earned by the fund.
## What is the process called that determines how much income is deemed to have been earned by each contract holder in a segregated fund?
- [ ] Distribution
- [ ] Apportionment
- [x] Allocation
- [ ] Disbursement
> **Explanation:** The income deemed to have been earned by each contract holder is calculated using a procedure known as allocation.
## What factors influence the income allocation to a segregated fund contract holder?
- [x] Number of units held and proportion of the calendar year the units were held
- [ ] The length of the contract term and holder's income level
- [ ] Investment strategy and market performance
- [ ] Total fund size and number of contract holders
> **Explanation:** Most funds allocate income based on the number of units held and the proportion of the calendar year during which those units are held.
## How do segregated funds differ from mutual funds in how they handle capital gains and capital losses?
- [x] Segregated funds pass both gains and losses to the contract holder; mutual funds do not
- [ ] Only segregated funds pass gains to the holder; mutual funds pass losses
- [ ] Both schemes handle gains and losses similarly
- [ ] Segregated funds and mutual funds reverse roles in handling gains and losses
> **Explanation:** Unlike mutual funds, where capital losses do not flow through to unit holders, segregated funds can pass both capital gains and losses to the contract holder.
## What happens to the net asset value per share (NAVPS) of a segregated fund after income is allocated?
- [ ] It declines significantly
- [ ] It remains constant
- [x] It increases the investor’s adjusted cost base and is reported for tax purposes
- [ ] It reduces to zero
> **Explanation:** A segregated fund does not suffer a decline in NAVPS after income allocation. Instead, the income is added to the existing units, increasing the investor’s adjusted cost base.
## Are maturity guarantee payments from a segregated fund contract taxable?
- [x] Yes, maturity guarantee payments are taxable
- [ ] No, maturity guarantee payments are always tax-free
- [ ] Only if they exceed a certain amount
- [ ] Only in non-registered accounts
> **Explanation:** Payments from a segregated fund contract's maturity guarantees are taxable, but the contract holder can use any loss as a capital loss, possibly resulting in a net zero tax effect.
## What is the tax treatment of death benefits from a segregated fund if the annuitant dies?
- [ ] They are always taxable
- [x] They are tax-free to the beneficiaries
- [ ] They are taxed only if the proceeds exceed $10,000
- [ ] They incur a capital gains tax
> **Explanation:** When the annuitant dies, the contract is terminated, and the beneficiaries receive the market value of the fund plus death benefits tax-free.
## What happens to the segregated fund contract if the contract holder dies but the annuitant is a different person?
- [x] The contract remains in force, and the deceased owner is deemed to have disposed of the contract at fair market value
- [ ] The contract automatically terminates, and beneficiaries receive the death benefits
- [ ] It is considered void and no benefits are paid
- [ ] The fund's NAVPS decreases
> **Explanation:** If the contract holder dies but is not the annuitant, the contract remains in force. The deceased owner is deemed to have disposed of the contract, possibly triggering a capital gain or loss unless transferred to a spouse.
## What is the tax consequence if a contract holder names a spouse as a successor owner?
- [ ] Immediate tax liability on capital gains occurs
- [x] The contract can be transferred to the spouse at its adjusted cost base, deferring any capital gains liability
- [ ] The contract is canceled
- [ ] It incurs a gift tax
> **Explanation:** If the contract holder names a spouse as the successor owner, the contract can be transferred at its adjusted cost base, deferring any capital gains liability.
## In what scenario will the gain or loss be reflected on the owner's terminal tax return for the year of death?
- [ ] Only if the contract has matured
- [x] If the contract owner and annuitant are the same person
- [ ] If the contract is transferred to an estate
- [ ] None of the above
> **Explanation:** If the contract owner and annuitant are the same person, the gain or loss is reflected on the owner's terminal tax return for the year of death.