Note: This is part five of a series on tax and insurance.
In part one we talked about the general tax attributes of life insurance. Part two looked at transactions resulting in a policy disposition, and how the proceeds and policy gain are determined. In part three we discussed the adjusted cost basis (ACB) of an insurance policy and how it’s determined. Part four reviewed how the net cost of pure insurance (NCPI) is calculated, and its impact on an insurance policy’s ACB and the collateral insurance deduction.
In this article we’ll delve deeper into the collateral insurance deduction—when it can be claimed and how it’s determined.
Criteria for deductibility
Premiums payable under a life insurance policy are generally not deductible for income tax purposes. However, a deduction is permitted where an insurance policy is collaterally assigned by the policyholder to secure a loan used by the policyholder to earn income from a business or property.
The following criteria must be satisfied to claim a deduction:
- The policy must be collaterally assigned for a loan from a “restricted financial institution,” defined under the Income Tax Act to include a bank, trust company, insurance company or credit union.
- Interest payable on the loan must be deductible in computing the policyholder’s income in the year (i.e., the borrowed funds are used to earn income from a business or property).
- The assignment must be required by the lender as collateral for the debt (which should be established by the loan documentation).
The policyholder must also be the borrower. For example, if a shareholder borrows funds from a bank, secured by the collateral assignment of a corporately owned policy, neither the policyholder nor the corporation is entitled to this deduction.
Assuming the above criteria have been satisfied, the amount that may be deducted is determined as that portion of the lesser of:
- policy premiums payable for the year and
- the policy’s net cost of pure insurance (NCPI) in the year,
which relates to the loan amount owing throughout the year.
Here’s an example to illustrate the calculation of the deduction.
Joyce borrows $100,000 from her bank at the beginning of the year to acquire shares in several public companies. The loan is interest only, and the bank requires Joyce to secure this loan by collaterally assigning a term insurance policy on her life with a death benefit of $250,000. The annual premium is $800, and the policy’s NCPI in that year is $600.
The lesser of the premium and the NCPI for the term policy is $600. This amount is pro-rated based on the loan amount outstanding throughout the year divided by the policy’s death benefit ($100,000 ÷ $250,000), which results in a collateral insurance deduction of $240 ($600 × 0.4).
If Joyce repays part of the loan in a following year, the repayment must be factored into the deduction calculation. Also, as a policy’s NCPI typically increases every year, it may eventually exceed the annual premium. At this point the annual premium would become the lesser amount for purposes of this calculation.
CRA has provided numerous interpretations relating to the collateral insurance deduction. Below is a summary of the most important interpretations.
- If the policyholder’s tax year is different from the policy year, the premiums under the policy should be determined for that taxation year. Similarly, if the policy is owned by a corporation with a non-calendar tax year, the NCPI (which is calculated on a calendar year basis) must be determined for the applicable taxation year.
- CRA has indicated that for policies without a contractual premium payment (such as a universal life policy), no deduction may be taken where the cost of insurance charges are funded by the policy’s cash value. In contrast, where a policy has required contractual premiums, and the premium is paid with internal values (for example, by a policy dividend), a deduction may be available.
- Additional security provided for the loan shouldn’t affect the amount of the collateral insurance deduction. As well, if several insurance policies are assigned as security (for example, where a corporation borrows money using insurance on two shareholders), a separate deduction is available for each policy using the above criteria.
- A corporation is entitled to a credit to its capital dividend account for the insurance death benefit (i.e., not net of any amount used to repay the debt), even where a collateral insurance deduction has been claimed in respect of that policy.
Type of insurance policy
It’s possible to use individual term insurance or a permanent insurance policy (with or without cash values) as security for a loan and qualify for the collateral insurance deduction. However, creditor insurance premiums aren’t deductible under this provision since the borrower isn’t the owner of the policy.
In the next article, we’ll explore the tax treatment of policy loans under a participating life insurance policy.
Kevin Wark, LLB, CLU, TEP is managing partner, Integrated Estate Solutions, and tax consultant, Conference for Advanced Life Underwriting. He’s also the author of The Essential Canadian Guide to Estate Planning.