Life insurance is almost always tax-free on death of the life insured. While that person is living and where the insurance is primarily designed to fund a death benefit, the policyholder still has no income tax concerns.
Where a policy has investment and savings features, the policyholder can be exposed to tax. Accessing a policy’s cash surrender value by way of a withdrawal will be a partial disposition, a portion of which will be taxable if the cash surrender value (CSV) exceeds the adjusted cost basis (ACB) at the time.
By comparison, generally no tax applies on a policy loan up to the ACB, but any amount over that would be taxable. And when a policy loan is used to investment outside the policy, there can be not-so-favourable tax implications. This was outlined in a CRA letter from mid-2017 in response to a taxpayer inquiry initiated about a year earlier.
Income Tax Act ss.20(1)(c) & (d), s.148(9) and Income Tax Regulation s.308
ITA ss.20(1)(c) & (d) allow a deduction for interest (simple and compound, respectively), where borrowed funds are used to gain or produce income. The relevance of this will become clear in the following discussion of the CRA letter.
There are numerous sections of our tax legislation and regulations that are networked together to address the complexity of life insurance. At the heart of it is s.148(9), and the many definitions contained therein, including what constitutes a disposition of a policy, how to calculate the proceeds on a disposition, and how to determine the portion of the disposition that is taxable.
As discussed in brief above, the determination of taxability depends on a policy’s ACB, also defined under s.148(9). The key components of ACB are paid premiums that increase it, and the annual charge of net cost of pure insurance (NCPI, as defined in ITR s.308) that reduce it. Importantly, taking a policy loan decreases ACB, whereas repaying the loan generally increases ACB.
CRA 2016-0658641E5 – What are the tax implications of capitalized loan interest?)
A policyholder contacted the CRA with concerns about the fairness of the tax treatment of life insurance. The policyholder’s loans and accrued interest comprised a debt owed to the insurer that will be deducted from any payout on the policy if still unrepaid at death. Even so, the policyholder received a T5 tax slip reporting taxable policy gains related to the policy loan.
The CRA representative outlined the key definitions in s.148(9) and elsewhere before turning to the details of this particular policy loan. The borrowed money was invested for the purpose of generating income, and the policyholder/taxpayer claimed the interest as a deduction pursuant to ITA s.20(1)(c) and/or (d). Furthermore, interest on the loan was not being paid by the policyholder directly; rather the interest was being capitalized within the policy.
The writer confirmed that the combination of claiming the interest deduction and capitalizing the interest resulted in a disposition pursuant to the definition of that term in s.148(9). In turn, the ACB must have been reduced to nil in the course of these dealings, as the disposition was confirmed as taxable.
- Life insurance generally accumulates tax-free, and pays out tax-free.
- A policyholder is more likely to face tax on a withdrawal than a policy loan.
- Sometimes a policy loan can result in tax, even though interest must be paid to the insurer and the loan amount reduces the death benefit.
- In a closing point in the 2017 CRA letter, the writer noted that many rules have been modified for policies issued after 2016. Check with your insurer how this may affect your policy dealings.