Permanent life insurance, whether it be universal life or whole life, can be a valuable tool for clients looking for tax-efficient capital accumulation of their “never money.” By never money, I mean money they will never spend in their lifetime and wish to pass on to their families or to charity after they’re gone.
One of the safety features built into most, if not all, permanent life insurance products is the ability to access the funds growing inside the policy by obtaining a policy loan from the insurer. Alternatively, it may be possible to pledge the life insurance policy as collateral to obtain a loan of up to 90% of the cash value from a willing financial institution.
A case (Neszt v. The Queen, 2019 TCC 139) decided this past summer, however, shows that there can be a dramatic difference from a taxation point of view between taking a policy loan versus taking a loan against the policy.
The case involved a taxpayer who held two life insurance policies with London Life. During the 2015 taxation year, he borrowed money from London Life against those two life insurance policies, which, for tax purposes, are deemed to be a disposition of his interests in the life insurance policies.
The taxpayer’s adjusted cost basis (ACB) of the life insurance policies represents mainly the sum of premiums he paid, less any dividends declared, if applicable, minus the net cost of pure insurance. Using an ACB of about $6,400 on the first policy and $11,000 on the second policy, London Life determined that his income from the disposition of the first policy was $7,200 and $19,200 from the second policy. That meant a total policy gain, taxed as ordinary income, of nearly $26,400.
As a result, London Life issued T5 slips in the amounts of $7,200 and $19,200, classified as “other source of income.” The taxpayer tried to argue in Tax Court that both amounts were non-taxable because they arose from personal loans taken from two personal whole life insurance policies under his name. In the taxpayer’s opinion, according to the reasons for judgment, this was “analogous and similar” to taking out personal loans with a financial institution, such as a chartered bank, which are non-taxable.
The judge did not agree, saying that life insurance policy loans should not be treated like personal loans from a financial institution “because life insurance policy loans are governed by specific provisions of the [Income Tax] Act.”
The act specifically states that a “disposition” in relation to an interest in a life insurance policy can be the result of a policy loan, which is defined as “an amount advanced by an insurer to a policyholder in accordance with the terms and conditions of the life insurance policy.”
As the judge explained, “the purpose of these complex rules is to ensure that a policyholder will include in his income any policy loan amount that is greater than the adjusted cost basis of his interest in the policy.” The judge also pointed out that a policyholder is entitled to claim deductions for all repayments made to the policy loan.
Since there was no evidence to show that London Life had incorrectly computed the amounts on the two T5 slips issued, the judge dismissed the case and upheld the taxation of the policy loans.
This is an important lesson for advisors to remind their clients that, in some cases, it may make more sense to use the policy as collateral for a loan from a financial institution, which would not trigger a deemed disposition, rather than take out a taxable policy loan.
Jamie Golombek , CA, CPA, CFP, CLU, TEP is the Managing Director, Tax & Estate Planning with CIBC Financial Planning and Advice in Toronto.