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Note: This is part two of a series on tax and insurance. Read part one.

In part one we talked about the tax attributes of life insurance. In general, the cash reserve within an exempt policy can accumulate on a tax-deferred basis, and the death benefit payable under the policy is tax-free. However, if the policy is disposed of prior to death, there is a taxable gain when the proceeds exceed the policy’s adjusted cost basis (ACB).

In this article we look at transactions resulting in a policy disposition, and how the proceeds and policy gain are determined.

Surrender or partial surrender

A common type of disposition is the cancellation or surrender of a policy. There are no tax consequences if the policy has no cash surrender value (CSV) — in other words, no proceeds — or the policy’s ACB is greater than the CSV. Where the policy’s CSV exceeds the ACB, the insurance company issues a T5 to the policyholder for the difference.

If only part of the policy is disposed of (i.e., the policy remains in force but some CSV is withdrawn), there is again no tax reporting if the ACB of the policy is greater than the full CSV. But where the policy’s CSV exceeds the ACB, a special rule determines how much of the policy’s ACB can be used to shelter the cash withdrawal.

Let’s say the policy’s CSV is $10,000, the ACB is $6,000, and $2,000 is withdrawn. The ACB allocated to the withdrawal equals $2,000 × $6,000 ÷ $10,000, or $1,200. The taxable gain is $800 ($2,000 − $1,200), and the policy’s ACB is reduced to $4,800.

Policy loans and dividends

A policy loan is an amount advanced by the insurer, under the policy terms, from the policy’s CSV. It’s not a loan in a commercial sense as it doesn’t have to be repaid.

A policy loan is a disposition of an interest in the policy, and a loan received in cash by the policyholder reduces the policy’s ACB. However, unlike a partial surrender, a policy loan results in tax reporting only where it exceeds the policy’s full ACB.

(Note that a collateral loan secured by a life insurance policy’s CSV isn’t considered a disposition.)

A policy dividend is an amount advanced under a life insurance policy and is considered a refund of excess premiums. As with a policy loan, the receipt of a cash dividend is treated as a disposition of an interest in the policy, and reduces the policy’s ACB and results in tax only if the dividend exceeds the policy’s full ACB. Where a policy dividend is used to pay premiums or purchase additional insurance within the same policy, special rules essentially result in no immediate tax reporting.

Non-arm’s-length transfers and gifts

A disposition also arises when a policy is transferred to a non-arm’s-length person or gifted to a charity. Special rules in subsection 148(7) of the Income Tax Act determine the proceeds on such a gift or transfer, as well as the ACB of the policy to the recipient.

These rules were revised in 2016. Where the transfer takes place after March 21, 2016, the transferor is deemed to receive proceeds equal to the greatest of:

  • the policy’s CSV,
  • the fair market value (FMV) of the consideration given for the policy or
  • the policy’s ACB at transfer.

Read: Life insurance loophole closed: example

For example, let’s assume Joan transfers her life insurance policy to a company she controls, for consideration equal to $100,000. The policy’s CSV is $30,000 and the ACB is $20,000. Jane is deemed to have disposed of the policy for $100,000, which is the greatest of the above listed amounts. This results in a taxable gain of $80,000. In turn, the company is deemed to have an ACB in the policy of $100,000.

Where the transaction is between a shareholder and a corporation, there are other tax nuances to these rules that must be considered prior to making such a transfer.

Similar rules apply on the gifting of an insurance policy to a charity. However, assuming the charity doesn’t pay for the policy, the donor’s proceeds will be the greater of the policy’s CSV and ACB. So if Joan transfers the same policy to a charity, she has a taxable gain of $10,000, and would receive a donation tax receipt of $100,000 (the policy’s FMV). Note that the donation tax receipt isn’t deemed to be consideration for purposes of these rules.

Read: How to donate a life insurance policy

Exceptions to the rules in subsection 148(7)

The following non-arm’s-length policy dispositions are generally deemed to take place at the policy’s ACB, resulting in no tax reporting for the transferor:

  • lifetime transfers of a policy (on any life insured) to a spouse or common-law partner, or to a former spouse or common-law partner in settlement of rights arising from marriage;
  • transfers on death to a spouse or common-law partner, provided that the life insured is the spouse or common-law partner of the deceased (note there is no rollover on the transfer of a policy to a testamentary spousal trust);
  • a transfer to a child of the policyholder for no consideration, where the child of the policyholder or child of the transferee is the life insured under the policy (note that the definition of child includes grandchildren). To qualify for the rollover, a transfer on death must occur by appointing the child as the successor owner in the contract rather than through the deceased’s will; and
  • the transfer of a policy from a trust to a capital beneficiary of such trust.

In the next article, we’ll discuss how a policy’s ACB is determined. This is important, knowing that the ACB is required to ascertain the taxable gain on a policy disposition, as well as the credit to the capital dividend account on a private corporation’s receipt of insurance proceeds.

Also read:

Capital Dividend Account changes proceeding

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.