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Note: This is part three of a series on tax and insurance.

In part one we talked about the general tax attributes of life insurance. In part two we looked at transactions resulting in a policy disposition, and how the proceeds and policy gain are determined.

In this article we discuss the adjusted cost basis (ACB) of an insurance policy and how it’s determined.

## ACB in action

Life insurance isn’t considered capital property, but it’s treated somewhat similarly when there’s a policy disposition. If the proceeds of disposition exceed the policy’s cost (i.e., the ACB), the resulting gain is fully included in the policyholder’s income.

ACB is also relevant where the insurance policy’s beneficiary is a private corporation. Generally, on the death of the insured, the insurance benefit is tax-free to the corporation. The excess of the death benefit over the policy’s ACB is credited to the corporation’s capital dividend account. This permits distribution of insurance proceeds as a tax-free capital dividend to the corporation’s shareholders.

## Math matters for ACB — but less than you think

An insurance policy’s ACB is a cumulative amount determined by the following formula:

(A + B + […] + G + G.1) – (H + I + […] + O)

To make things even more interesting, element O = [P × (Q + R + S)/T)] – U.

Generally, these elements represent various transactions that impact the tax value of the policy (some of the most important transactions are discussed below).

Obviously, it would be a daunting task for any policyholder to keep track of the policy’s ACB. Fortunately, the insurance company assumes the responsibility. A policyholder typically receives an annual or quarterly policy statement, which includes up-to-date ACB calculations.

Still, it’s important for insurance advisors to have a basic understanding of the ACB calculation, to both address client questions that might arise and to assist clients in determining the impact of certain policy transactions.

## Common transactions that affect ACB

The most common types of transactions that increase a policy’s ACB include:

• payment of life insurance premiums,
• payment (other than premiums) to acquire an existing life insurance policy,
• prior dispositions resulting in policy gains and
• repayment of a policy loan.

The most common types of transactions that decrease a policy’s ACB include:

• proceeds of disposition of a policy (whether full or partial), including a policy loan;
• payment of a policy’s fund reserve to provide an insurance or disability benefit (for policies issued after 2016);
• that portion of any premium or insurance charges that don’t relate to the benefit payable on death (for policies issued after 2016); and
• cumulative amount of the policy’s net cost of pure insurance (NCPI).

Should clients cash out an insurance policy?

Leveraging life insurance policies

## How recent changes to NCPI affect clients

A policy’s NCPI is defined in the regulations under the Income Tax Act, and is intended to reflect the policy’s annual mortality costs. The policy’s NCPI generally increases as the insured under the policy ages, which typically results in the policy’s ACB declining over time and becoming nil near life expectancy.

Certain changes have recently been made to the NCPI definition, which apply to policies issued after 2016. These changes generally result in a lower annual NCPI adjustment and, consequently, a higher ACB over the policy’s lifetime.

This is a positive change for policy dispositions, as any resulting gains will generally be lower.

However, this change can adversely impact corporately owned life insurance, as the credit to the capital dividend account from the death benefit may be lower.

In the next article, we’ll delve deeper into NCPI and how it’s calculated. We’ll also review how a policy’s NCPI is relevant to the collateral insurance deduction, which is available when an insurance policy is assigned as collateral for an investment or business loan.