By: Florence Marino B.A., LL.B., TEP | Vice President, Tax & Estate Planning
Every once in a while, a CRA technical interpretation comes out that explains the basic tax rules relating to life insurance dispositions. #2024-1041441E5 is an example. The reason why this occurs is that life insurance has a unique tax regime and taxpayers are sometimes caught off guard when they receive a T5.
Policy gains
In this case the taxpayer received a “return of premium” upon the expiration of a 20-year term insurance policy. This amount was taxable. Why? Because the surrender or dissolution by virtue of the maturity of a life insurance policy is a disposition. Upon a disposition, the “proceeds of the disposition” (in this case the amount received as a return of premium) in excess of the policy’s “adjusted cost basis” (ACB) is a policy gain that is taxed as ordinary income, like interest income. This income is reported on a T5.
ACB
But this was a term insurance policy with no cash value, why wouldn’t the ACB of the policy have been enough to protect the policyholder from tax in this situation? The ACB is not just premiums paid into the policy. It is a formula that reflects many ins and outs. One of the more relevant outs is the “net cost of pure insurance” (NCPI) which grinds down the ACB of the policy every year.
What is NCPI and why is there a grind?
NCPI is calculated in a prescribed manner by section 308 of the Income Tax Regulations. Depending on the date of issuance of the policy, mortality factors from an industry mortality table are applied to the net amount at risk under the policy. (In general, the net amount at risk under a policy is its death benefit less cash value. In the case at hand, the amount at risk is the death benefit amount.) This mortality factor is not the same as the actual mortality cost charged by the insurer to set the premium for the policy. For currently issued policies, to determine NCPI the Canadian Institute of Actuaries 86-92 mortality table is used.
Why does NCPI reduce the ACB of the policy? The ACB is supposed to reflect the cost of the investment component or savings element within a life insurance policy. The logic is that the NCPI should reduce this cost because NCPI represents the “true cost” of the risk/mortality component. In essence, the idea is that a policyholder has notionally paid that true cost, to deliver the death benefit and this amount should not contribute to the ACB.
How this comes through in respect of corporate owned life insurance
This same notion plays out in the context of the capital dividend account (CDA) credit for life insurance as well. Since the ACB represents the cost of the investment/savings component of the life insurance policy, it reduces the CDA credit for the death benefit received by a private corporation in calculating its CDA. The ACB includes premiums – those that fund mortality and cash value. NCPI adjusts for that portion of the premium, already included in ACB, that represents mortality risk. When paid at death, the entire death benefit is tax-free to the corporation. But from a CDA standpoint, only the portion that represents death benefit in excess of the cost of the investment/savings portion (i.e., ACB) should be able to be distributed tax-free from a corporation.
Unique tax regime
Life insurance is a different type of asset with a unique tax regime. Life insurance death benefits are received tax-free. A disposition of a life insurance policy is a taxable event that can give rise to T5 income. While the ACB of a policy can protect a policyholder from tax on disposition, the ACB is not simply the amount of premiums paid into the policy. Adjustments for NCPI reduce the ACB.
FOOTNOTE:
This publication is protected by copyright. Tompkins Insurance is not engaged in rendering tax or legal advice. TOMPKINSights contains a general discussion of certain tax and legal developments and should not be construed as tax or legal advice.
Should you wish to discuss this or any other TOMPKINSights article, please contact
florence@tompkinsinsurance.com
