Pros and cons of new life insurance rules

There’s been much discussion of the changes coming to life insurance tax rules in January of 2017 (see “New legislation will impact insurance tax benefits” ). One is the change to the Exempt Test Policy. The new rules will redefine the maximum amount of reserve a policy can have at each of its anniversaries. Generally, this will mean higher reserves in early years, and lower amounts in later years.

The other significant change is the introduction of a new mortality table for calculating a policy’s Adjusted Cost Basis (ACB). The revised table reflects Canadians’ longer life expectancies. Here, we’ll provide more context on the mortality table changes.

Net Cost of Pure Insurance

The formula for calculating ACB includes a factor called Net Cost of Pure Insurance (NCPI). Put simply, the NCPI reflects what the Department of Finance has identified as the mortality cost of providing insurance coverage.

The calculation for NCPI is: mortality factor x net amount at risk.

Table 1, below, compares mortality factors used to calculate the ACB of a policy issued to a 45-year-old, illustrating the mortality factor at five-year intervals.

Currently, the mortality factor for $100,000 of insurance for a 45-year-old male (non-smoker) is $104. Under the new schedule, the new mortality factor is $59. This 57% reduction in the mortality factor lowers the result of the NCPI formula outlined above.

Similar changes occur for all non-smokers. However, if the policy were issued to a male smoker, the new mortality rate factors for year 15 of the policy and onward are actually higher than the old factors. A female smoker would be neutral to the changes in factors about 10 years after the policy’s issued.

Table 1’s mortality figures are multiplied by the policy’s net amount at risk in determining the policy’s NCPI. In conjunction with the change in mortality factors, the new rules define the net amount at risk as the difference between the death benefit and the new policy’s reserve (which is generally higher than the old policy’s reserve). Current rules allow the carrier to use either the policy’s cash surrender value or the old reserve. A smaller mortality factor combined with a smaller net amount at risk means a much smaller NCPI.

NCPI is used to calculate both the policy’s ACB (as defined in Income Tax Act sec. 148(9)) and the tax deduction for collateral insurance (sec. 20(1)(e.2)). The ACB is used to calculate the credit to the Capital Dividend Account (CDA) of a private company, as well as the policy gain realized on disposition of the contract.

Figure 1 (below) compares the ACB under the current and new rules for a male, age 45, non-smoker. Higher ACBs resulting from the new rules have drawbacks and benefits.

Drawbacks

• Tax deduction for premiums paid for life insurance used as collateral will be lower because the NCPI is smaller under the new rules.
• Credit to a private company’s CDA equals the death benefit received less the company’s ACB in the contract. A company may elect to pay dividends as tax-free capital dividends (not applicable for U.S. citizens on filings to the IRS). To the extent the ACB is higher and remains higher for a longer period (see red line on Figure 1), the credit to the CDA is smaller.

Advantages

• • The deduction for premiums on rated life insurance policies used as collateral will be higher. That’s because the mortality figure used in the NCPI calculation will reflect the policy’s underlying rating—something not previously provided for.
  • A policy gain realized on disposition of a life insurance policy will generally be smaller, because the ACB will be higher for longer (see red line on Figure 1). A policy gain on the full surrender of the policy is the excess of the cash surrender value over the policy’s ACB. A policy gain on a partial surrender is calculated on a pro-rated basis, where the cash value withdrawn in excess of a portion of the ACB is recognized as a policy gain.

43%

The percent of Canadians who own or say they will purchase life insurance in the next 12 months.

Source: BMO

• Gains realized on policy dividends taken as cash are deferred longer, because the higher ACB offers a longer tax-free income period. When a policy dividend is taken as cash, there is a reduction in the policy’s ACB. Taxable income arises only when the ACB is reduced to zero.

Tax changes are significant when it comes to estate planning with corporate-owned life insurance. by James W. Kraft , CPA, CA, MTax, CFP, TEP and Deborah Kraft, MTax, TEP, CFP. James is vice-president, head of Business Advisory & Succession, BMO Nesbitt Burns, and Deborah is director, Master of Taxation Program, School of Accounting & Finance, University of Waterloo.