Bill C-43 implements the changes to the tax regime for insurance contracts that were first introduced in the 2012 federal budget speech. The primary changes that are implemented by this legislation are changes to the exempt test for life insurance policies, changes to the calculation of the adjusted cost base (ACB) of insurance policies, the introduction of a new disposition for multi-life universal life policies and an update of the taxation of prescribed annuities.The changes take effect on January 1, 2017 and apply to all insurance contracts issued on or after that date. Policies issued prior to 2017 will be grandfathered under the current legislation. This grandfathering will be lost, with the entire policy becoming subject to the new rules, if a grandfathered policy is converted or if new insurance coverage is added to the policy with medical underwriting. Underwriting to reduce insurance ratings or to reduce the premium of a grandfathered policy will not affect the grandfathered status of policies issued prior to 2017. Therefore, for example, underwriting to change an insured life from a smoker to a nonsmoker and changes to the cost of insurance rates on universal life policies will be permitted without affecting the grandfathered status of policies issued prior to 2017.
The changes in the taxation of insurance contracts are generally consistent with what was proposed in earlier draft legislation and discussion documents distributed by the federal Department of Finance. The most notable differences from the previous documents are the removal of the proposal to introduce an anti-avoidance provision that was exclusive to life insurance products, the clarification of the grandfathering rules described above and the deferral of the effective date of the changes to January 1, 2017. Although numerous technical details of the earlier documents have been modified in this final legislation, these modifications have little impact on the overall purpose and consequences of the legislation.
The general impact of the changes in the legislation will be:
- a reduction in the maximum premiums and/or deposits permitted in an exempt policy;
- a lengthening of the “quick-pay” period possible under any given set of assumptions in an illustration;
- lower permissible maximum cash value accumulations inside exempt insurance policies, especially at later policy durations;
- for most insurance policies, higher ACBs that remain positive for a longer period of time; and
- higher taxable portions for the income from prescribed annuity contracts.
A new mortality table will be used to determine the taxable portion of prescribed annuity contracts issued after 2016. This change will increase the portion of each annuity payment that is deemed to be taxable income to the annuitant.
The exempt test compares the savings component of a life insurance policy to the savings component of a hypothetical benchmark policy. To be exempt, the savings component of the policy may not exceed that of the benchmark policy. The legislation makes changes to the hypothetical benchmark policy and to the calculation of the savings component of both the benchmark policy and the actual policy. The net result of these two changes for most insurance policies is generally neutral in the first 8-12 policy years (i.e. no material increase or decrease in maximum premiums/deposits) and lower permitted savings thereafter. Universal Life policies that apply relatively large surrender charges will see material reductions in maximum premiums/deposits in all policy years. Participating whole life policies will be subject to both changes and will also experience lower permitted savings as a result of these changes.
The legislation mandates a newer mortality table be used to determine net cost of pure insurance (NCPI) in the calculation of the ACB of a policy. It also mandates that the new reserve calculation for the determination of the savings component of a policy be used in determining the net amount at risk in the calculation of the NCPI of a policy. These changes will result in lower NCPIs under the new legislation, resulting in higher ACBs that remain positive for a longer period of time. Higher ACBs will generally be advantageous to policyholders with respect to withdrawals and other policy dispositions but will generally be disadvantageous to the Capital Dividend Account (CDA) credit available to corporate-owned policies upon the death of an insured person. Lower NCPIs will also mean that lower amounts may be deductible by policyowners in respect of policies that are assigned as collateral to secure a loan.
The legislation specifies that ratings be incorporated into the mortality table considerations for both taxable income calculations for prescribed annuity contracts and NCPI calculations in the ACBs of life insurance policies. The general conclusions summarized above for both prescribed annuities and ACBs may therefore not apply for rated annuities and rated life insurance policies.
The payment of account value on first death from multi-life policies will be treated as a partial disposition where that payment exceeds what could have been paid had the coverage giving rise to the death benefit been a stand-alone exempt insurance policy.
Overall the changes are consistent with the stated intention of Finance to update and modernize the tax regime for life insurance contracts. Although the changes that arise from the new legislation will be material, they are not extreme and will not generally be disruptive to the value that life insurance and annuities provide to owners of these policies. The changes are best described as evolutionary, not revolutionary.
Steve Krupicz, FSA, FCIA, HBSc
AVP Regional Actuarial and Underwriting Consultants at Manulife Financial