Under s. 138.1 of the Income Tax Act (Canada), every segregated fund is deemed to be an inter vivos trust (a "related segregated fund trust") for tax purposes. The insurer acts as trustee. This trust classification has the following practical effects:
T3 slip: Each year, the insurer issues a T3 -- Statement of Trust Income Allocations and Designations to the contract owner of a non-registered contract. The owner includes the allocated income in their tax return for that year.
Annual allocation -- "phantom income": Under s. 138.1, the taxable income of the related segregated fund trust is deemed to be paid out to the contract owner each year, even if no cash was actually distributed. This means the owner may owe tax on income that was reinvested inside the contract. This is the same mechanism that governs mutual fund trusts (mutual funds also issue T3s), so this feature is not unique to segregated funds. However, it distinguishes both products from a corporation (whose shareholders pay tax only when dividends are paid or shares are sold).
Income character is preserved: Capital gains earned inside the fund flow through to the owner as capital gains (eligible for the 50% inclusion rate); eligible Canadian dividends retain their dividend tax credit eligibility; foreign income is taxed at full marginal rates. The character of income is preserved as it passes through the trust to the owner.
Adjusted Cost Base (ACB) tracking: The owner's ACB increases by each deposit and by income reinvested into the contract. The ACB decreases on each partial withdrawal. Accurate ACB tracking is necessary to calculate the capital gain or loss on surrender or maturity.