In an earlier article we looked at the requirements to qualify for the collateral insurance deduction under the Income Tax Act (ITA). Despite well-established Canada Revenue Agency (CRA) guidelines, some taxpayers believe they can simply deduct the full amount of premiums paid when the policy is assigned to secure a loan.
This misconception is illustrated in the recent case of EMJO Holdings Ltd. v The Queen (2018 TCC 97). The case facts are straightforward, at least at first blush. EMJO claimed a collateral insurance deduction for the 2013-2015 tax years relating to premiums paid on two life insurance policies used to secure business loans. CRA disallowed the deductions because in its view the borrower wasn’t EMJO but rather EMJO’s shareholders.
This assessment would have been fatal to EMJO’s appeal, as the rules require that the borrower and policyholder be the same person to claim the deduction. EMJO disagreed and appealed CRA’s assessment to the Tax Court of Canada.
First loan failures
The first policy, a universal life plan for $1 million, was purchased in fall 2002 when EMJO acquired the shares of another company. To finance the acquisition, term loans totalling $550,000 were arranged through a credit union. One of the loan requirements was maintaining at least $500,000 of insurance coverage on the life of a principal shareholder.
Although the commitment letter for the first loan was addressed to the shareholders, the court accepted that this obligation was subsequently adopted by EMJO and that the funds were advanced to EMJO. The court also found that the policy was assigned to the lender, despite a lack of supporting documentation.
So far, so good for EMJO in terms of claiming a collateral insurance deduction for the policy.
However, the court went on to note there were other problems with the deduction claimed for the policy:
- The policy was for $1 million and was later increased to $2 million, but the lender required the assignment of life insurance in the amount of only $500,000. Thus, the deduction should have been pro-rated based on the total amount of insurance required by the credit union in relation to the total face amount of the policy (i.e., about 25%).
- The loan balance of $66,152 was repaid in February 2013, which should have resulted in a further reduction to that year’s deduction. The repayment also meant there should have been no deduction available for the 2014 or 2015 tax years.
- EMJO failed to provide supporting evidence for the policy’s net cost of pure insurance (NCPI) for the tax years in question (the deduction is based on the lesser of premiums paid in the year and NCPI).
Based on this analysis, the court confirmed CRA’s assessment, and EMJO’s deduction in relation to the policy was denied.
Line of credit failures
EMJO acquired a second policy, term coverage of $3 million, in April 2011 as a requirement for obtaining a revolving line of credit of up to $2.4 million from a second lender.
The evidence indicated the lender required assignment of $500,000 of insurance to secure the line of credit. Again, the maximum deduction would be limited to the lesser of the term policy’s premiums for $500,000 of coverage and the related NCPI in the year. The deduction would be further limited by the outstanding amount of the line of credit “owing from time to time,” according to the ITA, in the 2013 to 2015 tax years.
Unfortunately, EMJO presented no evidence concerning the amounts owing under the line of credit during those years, and the court concluded it was unable to determine what deduction could be claimed without this information. In addition, the court indicated the term policy’s annual NCPI calculation was required in calculating the applicable deduction.
Thus, the court agreed with CRA that the full amount of deductions claimed by EMJO on both policies (approximately $26,000 from 2013-2015) should be disallowed.
Help clients avoid failures
Here’s a quick checklist for taxpayers to ensure they qualify for, and properly calculate, the collateral insurance deduction:
- The borrower and policyholder must be the same taxpayer to claim the deduction. This is an issue where, for example, a loan is advanced to a shareholder guaranteed by the assignment of a corporate-owned policy.
- The lender must be a restricted financial institution (essentially, a bank, credit union or insurance company).
- The policy must be required by the financial institution and assigned to secure the debt.
- The deduction is based on the lesser of the premium paid and the policy’s NCPI in the year. Keep records for both.
- The deduction will be reduced to the extent the life insurance death benefit exceeds the amount required by the financial institution or to the extent the outstanding loan amount in the year is less than the required insurance. Keep records of the security requirements and outstanding loan balances in the year.
Maintaining the proper records and performing the appropriate annual calculations will ensure your clients don’t spend unneeded time and money defending their claims for the collateral insurance deduction.