For some clients, a life insurance policy purchased in their 20s or 30s won’t meet their needs later in life — which may have some considering an ownership transfer. But before a policy changes hands, what are the tax implications? And what else should clients know? This article — the first in a 2-part series — focuses on life insurance transfers between individuals and within families.
Note: Throughout this article, references to specific legislative provisions are from the Income Tax Act (Canada) (ITA), unless otherwise indicated.
DEFINITIONS AND OTHER DETAILS
Disposition – The ITA defines the transfer of ownership of an interest in a life insurance policy as a ‘disposition’. When a policy owner disposes of their interest in a life insurance policy, it can result in a taxable gain. The amount of the gain is often based on the cash surrender value (CSV) of the policy, although other factors may come into play, depending on who’s involved in the transfer.
Because life insurance policies don’t fall into the tax category of capital property, taxpayers who dispose of their interest in a policy won’t realize a capital gain. Instead, it’s a policy gain, and 100% of the gain must be included in income. They can’t claim any losses to offset any gain.
ACB of a life insurance policy – The concept of adjusted cost basis (ACB) is defined in the ITA.1 The ACB is the cost of the interest the policy owner acquired in a life insurance policy. It’s one of the values used in calculating a policy gain.
The ACB is calculated according to a complex formula in ITA subsection 148(9). It’s increased by factors such as the amount of premiums paid, and reduced by others such as the net cost of pure insurance (NCPI).2 Information about the ACB amount is usually available from the life insurance company.
Taxes payable by policy owner on transfer – Generally, a transfer of a policy’s ownership is treated as a taxable disposition of the policy. The life insurance company will issue a tax slip showing the taxable amount, if any, that the policy owner who’s transferring ownership needs to include in their income.3
Depending on the relationship between those involved in a transfer, there may be additional factors to consider. In some cases, it’s necessary to determine the fair market value of the life insurance policy and whether it represents a taxable benefit for the new policy owner. We’ll explore this in part 2 of our series, which covers transfers of corporate-owned life insurance policies.
Arm’s length transactions – ‘Arm’s length’ transactions involve people who aren’t related to each other. The taxable income resulting from a disposition can differ depending on the type of transaction and if clients are dealing at arm’s length.
When clients deal at arm’s length, the provisions of subsection 148(1) and the definition of ‘proceeds of the disposition’ in subsection 148(9) will apply. The disposition price is the amount that was ‘paid’ and that the policy owner is entitled to receive.
Non-arm’s length transactions – ‘Non-arm’s length’ are transactions involving blood relatives, married couples (including common-law and same-sex partnerships) and adopted children. Non-arm’s length relationships may also exist between an individual and a corporation, a trust or two corporations.4
For non-arm’s length transactions, specific rules outlined in ITA subsection 148(7) apply. The amount a policy owner is entitled to receive is deemed to be the ‘value’ of the policy. Subsection 148(9) states that the value is the CSV of the policy, minus any policy loans, and without taking into consideration any dividends and interest payable on the loan. Where there’s no CSV (for example, with a term life insurance policy), this value is nil.
To determine the amount to include in the policy owner’s income, the ITA provides this formula:
Proceeds of disposition (the value of the policy) – ACB = Taxable policy gain
TRANSFERS BETWEEN INDIVIDUALS
For transfers among individuals, a popular but mistaken belief is that you can prevent a taxable disposition at death by appointing a contingent owner on a policy. Transferring ownership to an individual, either during the policy owner’s lifetime or at death, may still trigger a taxable gain. Tax-free transfers can only occur if the contingent owner qualifies under the terms of the ITA. Tax-free transfers are generally restricted to those between spouses or from parents to children (the term ‘child’ is broadly defined in the ITA). Both types of transfers are subject to rules that must be respected to ensure the transfer is, indeed, tax free.
Transfers to a spouse – There are two exceptions that allow for a tax-free ownership transfer of a life insurance policy between individuals. The first is a transfer between spouses (during the policy owner’s lifetime or at death), if the policy owner and spouse are residents of Canada at the time of transfer. The definition of spouse includes married spouses, common-law partners and same-sex partners.
During the policy owner’s lifetime, this definition also includes former spouses or common-law partners when the transfer occurs to settle rights arising out of the marriage or common-law partnership.5
Even though a transfer to a spouse doesn’t have any immediate tax implications for the transferor, it’s important to keep the attribution rules in mind. During the policy owner’s lifetime, if the spouse takes a policy loan, attribution rules may require the policy owner who transferred ownership to include the taxable part of the withdrawal or loan in their income (unless the transfer was made to settle rights arising from marriage or common-law partnership).6
The right of survivorship that applies to joint owners of an asset under common-law7 does not exist under civil law.
Transfers to a child – The second exception involves transfers from a parent to a child. The definition of ‘child’ is quite broad, and includes grandchildren and great grandchildren.8
Subsection 148(8) allows for a tax-free transfer to a child when:
- the policy is transferred to the policy owner’s child for no consideration (i.e., nothing of value is given in exchange for the policy), and
- the life insured is the policy owner’s child or the transferre’s child.
Initially, transfers to a child may seem straightforward, but that isn’t always the case. For example, the child to whom the policy is transferred doesn’t have to be the same child as the life insured. Consider a grandparent who owns a policy on a grandchild’s life. They could transfer that policy to their own child (the grandchild’s parent), as long as the requirements in the ITA are respected.
Another wrinkle: Subsection 148(8), which allows tax-free transfers, doesn’t apply to insurance policies transferred from parent to child by means of the policy owner’s will.9 When a policy owner dies, the policy is first transferred to the estate, and then to the child. This results in a disposition of the policy by the deceased policy owner, and any gain realized on the policy must be included in the deceased’s final tax return.
Consequently, a life insurance policy can’t be bequeathed in a will and qualify for a tax-free transfer. The only way around this is to name a contingent owner in the policy who meets the requirements noted above. This way, tax isn’t payable on the policy owner’s death.
BEFORE A TRANSFER
The tax implications of life insurance policy transfers can be complicated and difficult to assess. Before proceeding with a transfer, encourage clients to talk with their tax and legal advisors.
You can also learn more. Tax implications when transferring ownership of a life insurance policy, published in May 2015 by Sun Life Financial (authored by Jean Turcotte, B.A.A., LL.B., Director Tax, Wealth and Insurance Planning Group), includes more detail and several examples.
1 See definition of ‘adjusted cost basis’ under subsection 148(9) ITA; sections 976 and 976.1 of the Quebec Taxation Act
2 Subsection 308(1) Income Tax Regulations
3 Subsection 56(1)(j) ITA
4 Subsection 251(1) and 251(2); sections 18 and 19.1 TA
5 Subsections 148(8.1 and 8.2) ITA; sections 971.2 and 971.3 TA
6 Subsection 74.1(1) ITA; section 462.1 TA
7 Generally, the right of survivorship is a right where, at death, the interest of the deemed joint owner is transferred to the surviving joint owner(s) by operation of law. For spouses residing outside Quebec, insurance policies should clearly specify that the right of survivorship applies.
8 In this case, the definition of ‘child’ is based on the definition found in subsection 148(9) ITA, which itself refers to the definition in subsection 70(10) TA
9 Confirmed by CRA technical interpretation no. 9433865 dated February 15, 1995