1 1506 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE Taxation of Life Insurance William J. Strain, FCA* PRÉCIS L élaboration d un régime fiscal équitable pour les sociétés d assurancevie et les titulaires de polices constitue un défi pour les responsables de l élaboration de politiques fiscales partout dans le monde. Le secteur de l assurance-vie comporte de nombreuses questions épineuses, y compris la nature éventuelle à très long terme d une police d assurance-vie, si, oui ou non, du point de vue d une politique sociale, les gains de mortalité devraient être imposés, si le revenu tiré du placement des réserves au titre des polices devrait être imposé et, le cas échéant, s il doit l être dans les mains du titulaire de police ou dans celles de la société d assurance. Il existe d autres complications en raison du caractère multinational du secteur canadien de l assurance-vie et du fait que presque la moitié de l assurance-vie au Canada est fournie par des sociétés mutuelles d assurance sur la vie, lesquelles sont détenues entièrement par les titulaires de polices. Ces facteurs entre autres ont eu une influence considérable sur l évolution du régime canadien d imposition de l assurance-vie. Avant 1968, les sociétés d assurance-vie et les titulaires de police étaient presque exemptés d impôt. Depuis l adoption d une structure officielle pour l imposition de l assurance-vie en 1968, des initiatives majeures de «réforme» ont été entreprises en 1977, en 1981, en 1987, en 1992 et en Nombre des propositions contenues dans ces réformes n ont pas été mises en place ou ont été adoptées sous une forme considérablement modifiée après une consultation auprès du secteur de l assurance-vie. Cette chronologie de l imposition de l assurance-vie au Canada s inscrit dans le contexte du secteur en évolution depuis les dernières décennies et de la récente révolution dans l élaboration de produits d assurance-vie. D une part, les changements survenus dans le secteur ont influencé considérablement l élaboration des politiques fiscales et, d autre part, les initiatives en matière de politiques fiscales ont largement influencé le secteur et l élaboration de produits en particulier. En tenant compte des racines et des tendances passées de l élaboration de l imposition de l assurance-vie, l auteur conclut en présentant certaines observations sur ce que pourrait réserver l avenir. * Of PPI Financial Group, Toronto. (1995), 1506 (1995), Vol. 43, Vol. No. 43, 5 / nno. o 55 / n o 5
2 TAXATION OF LIFE INSURANCE 1507 ABSTRACT Designing a fair tax system for life insurance companies and policy holders has long been a challenge for tax policy makers around the world. There are many difficult issues peculiar to the life insurance industry, including the very long-term contingent nature of a life insurance policy, whether or not mortality gains should be taxed from a social policy perspective, whether the income earned from the investment of policy reserves should be taxed and, if so, whether it should be taxed in the hands of the policy holder or the insurance company. Further complications arise because of the multinational character of the Canadian life insurance industry and the fact that almost half of all insurance in force in Canada is provided by mutual life insurers, which are owned entirely by their policy holders. These and other factors have had a significant influence on the development of the Canadian system of taxation of life insurance. Before 1968, life insurance companies and their policy holders were virtually exempt from tax. Since the introduction of a full-fledged structure for the taxation of life insurance in 1968, major reform initiatives were undertaken in 1977, 1981, 1987, 1992, and Many of these reform proposals either were not implemented or were introduced in substantially modified form after consultation with the life insurance industry. This chronology of life insurance taxation in Canada is set in the context of the changing industry over the past decades and the recent revolution in life insurance product design. Changes in the industry have had a significant influence on the development of tax policy; by the same token, tax policy initiatives have had a significant influence on the industry and on product development in particular. Reflecting on the roots of and past trends in the development of taxation of life insurance, the author concludes by offering some observations on what the future might hold in store. These are interesting times for the life insurance industry in Canada. The severe recession that began in 1990, triggering the collapse of real estate markets across North America, has taken its toll on the industry. The failure of a few life insurance companies over the past few years has focused attention and sparked widespread debate on solvency, consumer protection, and regulatory issues. The deregulation of the financial services sector, begun in the late 1980s, resulted in a tidal wave of restructuring in the banking, trust, and brokerage industries. The restructuring wave rolls on, and is likely to engulf the life insurance industry throughout the remainder of the decade as the last barriers to entry by other financial institutions come down. Despite tough economic times and the rapidly changing financial services marketplace, the Canadian life insurance industry remains strong. With investments of over $170 billion at the end of 1993, the industry is a
3 1508 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE powerful force in the nation s economy. Canadians rely heavily on individual and group life insurance. At the end of 1993, Canadians owned over $1.4 trillion of life insurance, more than triple the amount owned in As the population ages and as governments at all levels cut back on income support and other social programs, people are becoming increasingly concerned about their long-term financial security. The demand for new and innovative financial products and services to address these concerns is strong and growing. The taxation of life insurance companies and policy holders has a profound impact on the evolution of the industry and the creation of new products. In this, the 50th anniversary year of the Canadian Tax Foundation, it is timely to pause and reflect upon the development of Canada s system for the taxation of life insurance over the past 50 years. This article focuses primarily on the taxation of the policy holder. However, policy holder and company tax issues are interdependent. Consequently, reference is also made to the tax system for life insurance companies as it interrelates with policy holder taxation. This historical review is set in the context of the changing industry and, in recent years, the revolution in life insurance product design. There are valuable lessons to be learned from examining the roots and past trends in the development of the tax system for life insurance. Reflecting on the past may provide at least some hints as to the direction and extent of possible tax changes that will have a significant influence on the life insurance industry as it moves into the 21st century. TAX POLICY CHALLENGES The very long-term nature of the contractual commitments between the policy holder and the life insurance company creates difficult technical challenges in designing a fair and equitable tax system for life insurance companies and policy holders. A fundamental and highly charged political question is whether life insurance, which provides for the financial security of a deceased s dependants or indemnifies financial obligations and losses arising on death, is properly the subject of taxation. The peculiar difficulties of taxing life insurance companies and policy holders have bedevilled tax policy makers around the world for many years. The Canadian experience is no exception. To set the stage for the historical review of the taxation of life insurance, the following section describes the tax policy implications arising from the distinguishing characteristics of life insurance. The Long-Term Contingent Nature of Life Insurance A life insurance policy is a contract between a policy holder and an insurance company whereby, in consideration for the payment of speci- 1 Canadian Life and Health Insurance Association, Canadian Life and Health Insurance Facts, 1994 ed. (Toronto: CLHIA, 1994), 5.
4 TAXATION OF LIFE INSURANCE 1509 fied premiums, the insurance company agrees to pay to a designated beneficiary a certain sum at a specified future time or upon the happening of a specified contingency, usually related to survival of the person whose life is insured. 2 The policy is a contractual commitment on the part of the insurer that extends over many years. To put the long-term nature of the life insurance commitment into perspective, consider that a permanent policy issued on the life of a 30-year old when the Canadian Tax Foundation was established 50 years ago may just now be approaching maturity. Determining profit on an annual basis for the purposes of imposing an income tax is problematic for any business. To some degree, interperiod allocations of revenues and expenses are required for all businesses to properly match revenues with the costs necessarily incurred to earn such revenues and to reasonably apportion the income earned over the business cycle. Nowhere is this challenge more formidable than in the life insurance industry. The annual determination of profit for a life insurance business involves a process of estimating expected mortality, investment returns, and expenses over many years. The very essence of the life insurance business is the indemnification of contingent future liabilities. To calculate income, it is not only necessary to estimate the absolute amount of the contingent liability but also to determine when the liability will fall due so that its present value can be estimated. Mortality Gains and Losses Insurance is a business of risk intermediation. Life insurance provides financial protection against the risk of mortality over a period of time. The insurance company operates as an intermediary, pooling the risks on a large number of lives either directly or through reinsurance arrangements with other companies. Where a contract is issued on a yearly renewable term (YRT) basis, the premium, after a margin is deducted for expenses and profit, represents the amount that is required to pay claims. Over the whole insured population, there should not be a net mortality gain or loss. However, individual policy holders will receive either more or less than they contribute to the risk pool. Theoretical tax policy considerations aside, legislators ignore at their peril the social and political ramifications of taxing life insurance proceeds. Strong arguments can be made that individuals should be encouraged to provide for their own and their families protection. The rationale for taxing insurance proceeds received on death is difficult to explain, particularly at a time when beneficiaries are suffering a tragic sense of personal loss and financial insecurity. 2 Various contractual requirements are prescribed pursuant to the provisions of applicable provincial insurance legislation. The provincial legislation reflects the so-called Uniform Life Insurance Act adopted by all common law provinces. The provincial legislation in Quebec is broadly similar to the insurance law of the common law provinces.
5 1510 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE The co-operative nature or mutuality of the insurance arrangement is evident from the fact that almost half of the life insurance in force in Canada at the end of 1993 was provided by mutual life insurance companies, owned entirely by their policy holders. 3 Both mutual and stock companies can issue participating and non-participating insurance in Canada. Premiums for participating insurance are higher than those for insurance written on a non-participating basis. However, participating policy holders share in favourable mortality, expense, and investment experience by way of policy dividends. Important questions must be addressed by the tax policy makers. For example: 1) Are mortality gains and losses realized by individual policy holders properly included in the tax base? 2) Should policy dividends be treated as a return of excess premiums or as a distribution of the insurance corporation s after-tax income? 3) What provisions are necessary to ensure that the tax system does not create a bias between a mutual company, owned by its policy holders, and a stock company, owned by its shareholders? Savings Versus Protection The pure cost of insurance increases exponentially with age. On a YRT basis, the cost of maintaining permanent life insurance increases dramatically over time and becomes prohibitive at older ages. As an alternative to everincreasing premiums, the insured may choose to pay a level premium to average out the pure cost of insurance evenly over the term of the contract. Whether the policy covers a specified term or provides permanent coverage, premiums are almost always paid according to a schedule that results in the amounts paid during the early years of the contract exceeding the pure mortality cost for those years. Premiums paid in excess of the related mortality costs and expenses are accumulated and invested by the insurance company. This accumulating investment fund represents a reserve held by the insurer to back the obligations to policy holders. At the end of 1993, Canadian life insurance companies held reserves of approximately $25 billion backing individual life insurance policies. 4 The reserves affect the pricing and performance of a policy in two ways. First, in the later years of a policy when the premiums are not sufficient to cover the mortality cost, the shortfall can be drawn down from the policy reserve. Second, the reserve is available to pay a claim under the policy. Consequently, the net amount at risk under the policy is reduced, thereby reducing the cost of insuring that risk. 5 3 Supra footnote 1, at Ibid., at For a more comprehensive description of the interrelationship between the savings and protection elements of a life insurance policy, see William J. Strain, Life Insurance: An (The footnote is continued on the next page.)
6 TAXATION OF LIFE INSURANCE 1511 Many permanent insurance policies are designed so that the accumulating fund grows over time to equal the total amount of the benefit payable on death. At that time, the net amount at risk under the policy is completely eliminated and the policy is said to endow. Under most permanent life policies, there is a direct relationship between the accumulating fund held by the insurer and the cash surrender value (CSV) of the policy. The CSV is the amount the policy holder is entitled to receive upon the cancellation or surrender of the policy. Within a few years after issue, the CSV of the policy typically approximates the value of the related accumulating fund. Following the introduction of the term to 100 concept in the early 1980s, an increasing number of permanent policies have been designed with CSVs significantly less than their related accumulating funds. Simply stated, term-to-100 is a permanent life insurance policy, generally having guaranteed level premiums until age 100 and a guaranteed death benefit, but little or no cash value. Where such a policy is surrendered or lapses because of the non-payment of premiums, the excess of the accumulating fund over the CSV is forfeited by the policy holder and becomes available to pay the claims of other policy holders. The expected forfeitures are factored into the pricing of such policies and premiums are reduced accordingly. This type of policy is referred to as lapse-supported. The description of a life insurance policy as comprising distinct protection and savings components has long been a convenient but simplistic way to describe the complex nature of the contractual arrangements between the insurer and the policy holder. 6 In reality, a life insurance policy is a unified contract with the insurance and savings elements inextricably linked. The financial consequences to the policy holder will depend on whether the policy is retained and, if so, when and in what circumstances benefits are paid. Furthermore, the policy holder cannot ordinarily withdraw any of the cash values of the policy without adversely affecting the value of the insurance protection. Ultimately, the financial results emerge over a very long period. The conundrum of whether permanent life insurance represents decreasing term insurance coupled with an increasing savings account or the purchase of insurance protection on an instalment payment plan is highlighted in figure 1 and figure 2. 7 Both of these illustrations reflect a 5 Continued... Innovative Financial Instrument, in Report of Proceedings of the Forty-Fifth Tax Conference, 1993 Conference Report (Toronto: Canadian Tax Foundation, 1994), 35:1-34, at 35: A detailed analysis of a life insurance policy divided into two economic components first appeared in M. Albert Linton, Analysis of the Endowment Premium, Actuarial Notes feature (1919), 20 Actuarial Society of America: Transactions The conception of a life insurance policy as comprising two distinct elements of protection and savings was challenged in Robert I. Mehr, The Concept of the Level-Premium Whole Life Insurance Policy Reexamined (September 1975), 42 The Journal of Risk and Insurance
7 1512 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE $1,200 Figure 1 $1 Million Permanent Life Insurance Policy (Endow at Age 100) $1,000 $800 Net amount at risk Thousands $600 $400 $200 Reserve Age $1 million permanent life insurance policy issued on a 45-year-old male non-smoker. The policy shown in figure 1 has been designed to grow the CSV to an amount equal to the face amount of the policy at age 100 (the classic illustration of the decreasing term/increasing savings scenario). The policy shown in figure 2 has been designed to build a reserve just sufficient to defray future mortality costs and expenses so that the policy will lapse without value at age 100. The annual premium required to fund the policy shown in figure 1 is $12,555, compared with an annual premium of $12,515 required to fund the policy shown in figure 2. The difference is only $40 per year. 8 The situation is further confused by the fact that the financial results may differ considerably from those illustrated, depending on the actual amount of policy dividends or interest credited to the accumulating funds and the actual amount of mortality costs and expenses charged under the contract. In fact, the policy shown in figure 1 could actually lapse without value, or the policy shown in figure 2 could actually endow. 8 The insurance illustration is based on Security Fund, a universal life policy offered by the Prudential of America Life Insurance Company (Canada). The interest rate credited to the accumulating fund of the policy is assumed to be 6.5 percent annually. Annual premiums are assumed to be payable until the insured s age 100.
8 TAXATION OF LIFE INSURANCE 1513 $1,200 Figure 2 $1 Million Permanent Life Insurance Policy (Lapse at Age 100) $1,000 $800 Net amount at risk Thousands $600 $400 $200 Reserve Age The trouble is, in that mystical and magical world of actuarial science, what may or may not be 2, when multiplied by a factor that may or may not be 2, could possibly turn out to be 4, but probably will not! The relationship between the savings and protection elements of a life insurance policy raises the following tax policy questions: 1) Should the income earned from the investment of the policy reserves be subject to tax? If so, when? 2) If the investment income is to be taxed, should it be taxable in the hands of the insurance company or the policy holder? 3) If taxable in the policy holder s hands, how is the investment income earned by the insurance company to be allocated among policy holders? Level Playing Field The financial products and services provided by the life insurance industry may compete either directly or indirectly with financial products and services offered by other financial institutions. As the barriers separating the traditional pillars of the financial services sector have come down, the range of products and services offered by each type of financial institution has been significantly expanded. The tax policy maker must struggle
9 1514 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE to ensure that the tax system does not create an unfair competitive advantage for one financial institution over another. Regulatory Versus Tax Policy Issues The life insurance industry is closely regulated because of public concern over the protection of policy holders and the stability of the country s financial institutions. The objectives of the regulatory authorities and those of the tax system are in conflict. How can such conflicting objectives be reconciled? For example, does a restriction on the deductibility of actuarial reserves by a life insurance company impair the strength of the company? Product Innovation and Development Fifty years ago, the development of a new life insurance product was a mammoth undertaking that required an incubation period of many years from conception to delivery. Today, the lead time for bringing a new product to market has shrunk to a matter of months. The challenge for the tax policy maker is to design a system that is based on sound fundamental principles and that is sufficiently flexible to adapt to a rapidly changing marketplace. The tax system should not impede new product innovation either by imposing a set of complex and detailed technical rules or by creating an unnecessary air of uncertainty over the application of the rules to new and innovative products. It is against this backdrop of tax policy issues and challenges that the evolution of Canada s system for the taxation of life insurance is examined. BEFORE CARTER Industry Environment During the 20 years between the Canadian Tax Foundation s establishment in 1945 and the mid-1960s, the Canadian life insurance industry could perhaps best be described as staid, conservative, and steeped in tradition. The industry was dominated by a relatively small number of large companies offering a narrow range of products. The products sold throughout this period included mainly whole life (participating and non-participating), limited pay life, endowment, and term policies. In 1960, whole life accounted for almost 75 percent of all individual life insurance owned by Canadians. Product pricing was typically based on level premiums fixed at the time the policy was issued. The amount of death benefit was ordinarily established at the time of issue and remained unchanged throughout the duration of the contract. The CSV of the policy at any point in the term of the contract could be determined at the time the policy was issued. New product introductions were rare, and existing products were repriced only every 5 to 10 years. The policies were characterized by complex contractual language, little disclosure of the design elements or factors involved, and very limited flexibility or available options.
10 TAXATION OF LIFE INSURANCE 1515 Tax System Life insurance was virtually exempt from income tax at both the company and the policy holder level until The Income War Tax Act of 1917, the first income tax statute in Canada, provided an explicit exemption for policy holders on the proceeds of life insurance policies paid upon the death of the person insured, or payments made or credited to the insured on life insurance endowment or annuity contracts upon the maturity of the term mentioned in the contract or upon the surrender of the contract. 9 A tax exemption was also provided for the income of life insurance companies except such amount as is credited to shareholders account. 10 Consequently, only the net earnings of stock life insurance companies which were allocated to shareholders (whether or not distributed) were subject to corporate income tax. Mutual life insurance companies, having no shareholders, were fully exempt. When the Income War Tax Act was overhauled in 1948, this same principle was carried forward. However, the explicit exemption was withdrawn. Instead, the exemption was implicit in the definition of the taxable income of a life insurance company, which included only amounts credited to the shareholders account. 11 The specific exemption for life insurance proceeds received by a policy holder was also dropped in the new Income Tax Act in However, the minister of finance, Douglas C. Abbott, stated in the House of Commons that [t]here is this privilege, that earnings of life insurance policies are exempt from taxation, and properly so. 12 On the basis of this philosophy, gains realized on death, maturity, or surrender of life insurance policies were not taxable before Beginning in 1940, life annuities became taxable in full. However, only the interest element of annuities that were issued for a specified period was subject to tax. Life annuities with guaranteed periods were taxable only on the interest element during the guaranteed term but on the full amount thereafter. This procedure raised a public outcry of dissatisfaction and led to the appointment of a royal commission on the taxation of annuities. The Ives commission recommended that annuities be taxed on the principle that a portion of each payment is in part a tax-free return of capital and in part taxable interest income. A simple rule of thumb was adopted to calculate the tax-free capital element to be the level amount obtained by dividing the purchase price by the term (in years) or, in the case of life annuities, by the expectation of life. 13 These recommendations 9 SC 1917 c. 28, section 3(1). 10 RSC 1927, c. 97, section 4(g). 11 Income Tax Act, SC 1948, c. 52, section Canada, House of Commons, Debates, June 1, 1948, Canada, Report of the Royal Commission on the Taxation of Annuities and Family Corporations (Ottawa: King s Printer, 1945).
11 1516 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE for the taxation of annuities were adopted in 1945 and survive today as the basis for the taxation of prescribed annuities. Although the interest element of annuity payments was taxable, there was no provision in the legislation to tax the proceeds received on the surrender of a deferred annuity contract before the commencement of periodic payments. This loophole eventually led to a widespread practice of purchasing deferred annuities with the intention of cancelling them before maturity in order to receive tax-free gains. In 1963, the Income Tax Act was amended to block this perceived abuse by taxing as interest income any gain realized on the surrender of an annuity contract, other than on death. 14 THE 1960S Industry Environment During the 1960s, the winds of change began to blow through the life insurance industry. The economic climate was undergoing a fundamental change as interest rates started to rise, fuelled by intensifying inflationary pressures. Life insurance policy holders were becoming increasingly disenchanted with traditional permanent insurance as an investment. More and more whole life policy holders were advised to buy term and invest the difference. By the end of the decade, the percentage share of the individual life insurance market represented by whole life policies had dropped from about 75 percent to just over 60 percent. The availability of increasing computing power permitted the faster development and maintenance of new and more complex products. The pricing of existing products was also changed more frequently in response to changing economic conditions. Insurance mortality rates were improving with advances in medical science and health care, resulting in lower insurance costs. Competition within the industry was also intensifying as new and smaller companies entered the market and more foreign-owned insurance companies ventured into Canada. These newer entrants into the market could afford to pursue market share by developing new and competitive products without the concern about their possible impact on existing blocks of in-force business. Tax System Yesterday, all my troubles seemed so far away. Paul McCartney, 1965 By 1962, Canada s tax system was sadly in need of repair. Corporate surplus stripping had become an issue of major concern. Literally dozens of techniques had been designed to enable shareholders to convert taxable dividend distributions into tax-free capital gains realized on the disposition of shares. The government feared that these and other tax-planning 14 SC 1963, c. 21, section 3, adding subsection 7(5) to the Income Tax Act, RSC 1952, c. 148, as amended.
12 TAXATION OF LIFE INSURANCE 1517 strategies were threatening to seriously undermine the integrity of the entire structure. A royal commission on taxation (the Carter commission) was appointed to investigate and make recommendations for improvements. After an exhaustive inquiry, the Carter report was released in 1966, recommending that the government scrap the existing system, start over, and create an entirely new tax structure built on the commission s concepts of equity and neutrality. 15 The Carter report was a watershed in the evolution of tax policy in Canada. The commission forever changed the environment for the taxation of life insurance. Particular recommendations put forward in the Carter report must be considered in the context of the full integrated model tax system proposed by the commission. Simply stated, a fundamental guiding principle for the new tax system was that taxes should be imposed according to a person s ability to pay. It is our view that the adoption of the comprehensive tax base we recommend would greatly improve taxpayer equity by bringing virtually all increases in economic power into tax. Such a tax base would also have the very desirable ancillary benefit of substantially eliminating the uncertainty, and the various opportunities for tax minimization and avoidance, that we have found in the present system, because virtually all net gains would be taxable to residents at full personal rates. 16 On the basis of this a buck is a buck concept of the tax base, the commission s recommendations for the taxation of life insurance should not have come as any great surprise. In summary, the commission recommended: 17 1) Life insurance companies should be taxed at regular corporate rates on operating income not passed through to policy holders. However, through the gross-up and credit mechanism proposed for taxing dividend income, the corporate tax rate would ultimately be adjusted to the personal tax rates of individual shareholders. A similar process should apply to mutual insurance companies with respect to gains held for the benefit of participating policy holders. 2) Premiums paid for a life insurance policy (other than for employersponsored group life insurance) should not ordinarily be deductible in computing taxable income. 3) In general, investment income accumulated for the benefit of the policy holder should be included in the policy holder s income in the year it is accumulated in the hands of the insurer. The commission recognized that the feasibility of this recommendation depended on finding a procedure which is satisfactory from the points of view of both equity and ease 15 Canada, Report of the Royal Commission on Taxation (Ottawa: Queen s Printer, 1967) (herein referred to as the Carter commission or the Carter report ). 16 Ibid., vol. 3, at Ibid., vol. 4, at
13 1518 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE of computation for allocating to individual policyholders the investment income credited to policy reserves. 18 As an alternative, the commission proposed a system of withholding taxes under which the insurer would pay tax on investment income credited to policy reserves when accrued; the policy holder would receive a credit at the time benefits were paid (the blueprint for the investment income tax). 4) Policy dividends should be included in the income of the recipient. 5) Mortality gains and losses should eventually be included in the computation of the income of policy holders. However, the commission did not recommend the immediate inclusion of mortality gains and losses in the tax base, primarily because the other recommendations involved such a substantial change in the tax treatment of life insurance. The life insurance industry was the first to feel any real impact from the Carter report. In his 1968 budget, Finance Minister Edgar Benson proposed a full-fledged structure for the taxation of life insurance. Although they did not go nearly as far as the Carter commission recommended, the 1968 proposals nevertheless represented radical change. Two new separate taxes were proposed, one at the policy holder level and one at the corporate level. When introducing these proposals, Finance Minister Benson said: It is essential as well, I believe, in terms of equity between those who save in the form of insurance policies and those who save in other forms, to levy some tax on the investment income which policyholders receive through the insurance companies. 19 Mr. Benson also said that his proposals would constitute a much simpler and more practical method than the method recommended by the Carter commission, and should achieve substantially similar equity. 20 After intensive consultation with the life insurance industry, the budget proposals were implemented, with some modifications, through amendments to the Act and the regulations in The new taxes on life insurance introduced in 1969 are summarized below. Policy Holder Gains Gains realized by a policy holder on the surrender or maturity of a life insurance policy (but not on death) became fully taxable. The accumulated policy reserves, when received as part of the benefit payable upon death, continued to be tax-free, as were pure mortality gains. Carter s recommendation to tax income credited to policy reserves in the hands of policy holders on an accrual basis was rejected. 18 Ibid., vol. 3, appendix C, at Canada, Department of Finance, 1968 Budget, Budget Speech, October 22, 1968, Ibid.
14 TAXATION OF LIFE INSURANCE 1519 The amount to be included in taxable income upon the disposition of a policy was the excess of the proceeds over the adjusted cost basis (ACB) of the policy holder s interest in the policy. Generally, the ACB was the aggregate of premiums paid. Policy dividends were treated first as a reduction of the ACB and therefore were not currently taxable until such time as the total dividends received exceeded the total premiums paid or until the policy was surrendered or matured (other than as a consequence of death). Special grandfathering treatment was accorded to life insurance policies that were in force on October 22, 1968, to avoid retroactive taxation of gains already accrued. Segregated Funds A segregated fund policy is a variable life insurance contract under which a portion of the premium is placed in a separately administered investment portfolio. The proceeds receivable by a policy holder under such a policy at any time will depend on the value of the securities held in the segregated fund. At the urging of the life insurance industry, the government adopted a flowthrough treatment for segregated fund policies. Provision was made for the insurer to allocate investment income earned on the segregated fund to the policy holder on an annual basis. The character of the investment income as dividends, interest, and income from other sources was preserved and taxed as such in the policy holder s hands. The proportionate amounts of foreign taxes paid and depletion allowances were also allocated and made available to policy holders as credits and deductions. The flowthrough treatment for segregated funds was intended to establish a level playing field with the mutual fund industry for investment products that were substantially similar in nature. Investment Income Tax In 1968, the government had concluded that there was no simple and practical method of taxing in the policyholders hands the investment income which benefits them by way of reduced premiums or increased policy dividends. 21 To take the place of a tax on the individual policy holders, a 15 percent tax was imposed on the taxable Canadian investment income of the insurance companies. The calculation of this investment income tax (IIT) was not simple and, in many respects, was very arbitrary. The starting point was to allocate gross investment income between Canadian and foreign life insurance operations (excluding income related to segregated funds, registered retirement funds, and grandfathered policies). Deductions were then allowed for investment expenses and a purely arbitrary 50 percent of the company s general expenses incurred in its Canadian operations (including commissions but excluding premium taxes). 21 Ibid.
15 1520 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE The 50 percent factor was intended to deny a deduction for those expenses related to the risk element of the life insurance business. Amounts received by policy holders representing the taxable element of annuity payments and taxable gains realized on the surrender or maturity of policies were deducted in calculating taxable Canadian investment income. The result of this deduction was that the company recovered the tax it paid on investment income when such amounts became taxable to the policy holder. A deduction was also allowed for the amount of income subject to regular corporate income tax. 22 Corporate Income Tax The 1969 amendments brought insurance companies into the tax net for the first time: the amendments provided that: 1) All insurance companies, both stock companies and mutual companies and life and non-life companies, were deemed to be carrying on business for profit. 2) All premiums were deemed to be received in the course of business. 3) All investment income was deemed to be income of the corporation. 4) Income and taxable income was determined according to rules applicable to all other corporations, except as otherwise provided. 23 The special provisions applicable to life insurance companies included the following. Canada-Only Principle Only income earned from carrying on a life insurance business in Canada was subjected to tax. 24 This principle, which continues today, is a significant departure from the normal approach of taxing Canadian-resident companies on their worldwide income and allowing credits for foreign taxes paid. Here again, extraordinarily complex and often arbitrary rules were developed to allocate income between Canadian and foreign operations. In adopting the Canada-only approach for life insurance companies, the government recognized that many companies operated internationally through foreign branches. Such companies may have been placed at a severe competitive disadvantage if a worldwide basis of taxation were abruptly imposed. Capital Gains The 1969 amendments specifically provided that the investment income of a life insurance company would include realized gains and losses and the amortization of premiums and discounts on Canada securities 22 SC , c. 44, section 28, adding sections 105R to 105U to the Act. 23 Ibid., section 15, adding section 68A to the Act. 24 Ibid., adding subsection 68A(2) to the Act.
16 TAXATION OF LIFE INSURANCE 1521 mainly bonds, debentures, and mortgages, but not equities. 25 For most other companies, such amounts were considered capital gains or losses and consequently were not taxable. Policy Reserves Regulations were developed in 1969 to determine the maximum tax actuarial reserves (MTAR) allowable in calculating a life insurance company s income for tax purposes. 26 The MTAR were not necessarily the same as reserves reported in the company s annual filings with the federal regulators. The government was concerned that the statutory reserves were ultraconservative and would result in a significant understatement of income if allowed for tax purposes. Reserves for life insurance policies (and individual deferred annuities) with guaranteed cash values were based on the net level premium method, using the same mortality and interest assumptions implicit in the determination of the cash values. Reserves for other policies were calculated pursuant to the net level premium method, using the same interest and mortality assumptions as used for statement reserves. In general, reserves for annuities (other than deferred annuities with guaranteed cash values) were calculated using the same mortality tables and at interest rates 1 percent lower than those used in calculating premiums. The life insurance industry made strong representations to the government and the Senate Finance Committee for the allowance of additional contingency reserves. Industry representatives sought recognition of the highly contingent nature of mortality risks and the potential of experiencing adverse results with regard to investment yields and expenses over the long-term duration of a life insurance contract. However, the government did not agree; in its view, there was already some margin for contingencies in the MTAR, and other types of corporations are not permitted deductions for contingency reserves. The government also felt that the effects of any unusual losses could be cushioned by an effective unlimited carryforward of losses available to life insurance companies through their discretionary ability to claim as a deduction any amount of policy reserves up to the MTAR. Policy Dividends Dividends paid to the owners of participating life insurance policies were deductible, subject to specified limits. 27 In general terms, the limit was the pre-dividend, pre-tax earnings from the individual and group participating 25 Ibid., adding paragraph 68A(4)(b) to the Act. 26 Ibid., adding subparagraph 68A(3)(a)(i) to the Act and SOR/ (1969), vol. 103, no. 24 Canada Gazette Part II , adding regulations 1400 and (Unless otherwise stated, all references to regulations in this paper are income tax regulations made pursuant to the Income Tax Act.) 27 SC , c. 44, section 15, adding subparagraph 68A(3)(a)(iv) to the Act.
17 1522 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE life business. The deduction was available in advance in the form of a reserve for future policy dividends that were payable out of current earnings. Deduction for Investment Income Tax The IIT was allowed as a deduction in computing income subject to the basic corporate tax. 28 Because the amount of such income was also deductible in determining the base on which the IIT applied, the determination of each level of tax required a complex circular calculation. Dividends Paid to Shareholders Before 1969, tax was payable by stock life insurance companies on dividends paid or credited to shareholders. To preserve continuity and to ensure that large accumulations of surplus before 1969 did not escape tax, the 1969 amendments provided that subsequent dividends would also trigger corporate tax to the extent that they exceeded earnings accumulated after the new system was implemented. 29 THE 1970S Industry Environment Economic Conditions The 1970s brought rapidly increasing interest rates, runaway inflation, and high budget deficits. The average yield on long-term Canada bonds, just under 7 percent in 1970, rose steadily throughout the decade to over 11 percent by The average annual increase in the consumer price index, around 3 percent in 1970, hit double digits in 1975 before retreating to just over 9 percent by These conditions caused policy holders to question whether traditional life insurance policies offered sufficient economic sensitivity and flexibility. Sales of both participating and non-participating whole life insurance policies began to dry up as consumers perceived better financial returns available through other savings and investment products. At the end of 1979, more than half of all individual life insurance owned by Canadians was in the form of term policies. 30 Insurers also began to experience cash flow problems as dissatisfied policy holders either surrendered their policies or took out policy loans at interest rates substantially below market. Inflation was also driving up operating costs at a time when premium income was either static or falling for some companies. Product Development To compete in a dynamic and rapidly changing investment climate, the traditional participating and non-participating whole life insurance products had 28 Ibid., adding subparagraph 68A(3)(a)(vii) to the Act. 29 Ibid., adding subsection 68A(7) to the Act. 30 Supra footnote 1, at 13.
18 TAXATION OF LIFE INSURANCE 1523 to change. Innovative new insurance product ideas began to emerge across North America in the early 1970s. This trend intensified throughout the decade, and precipitated a revolution in product design. 31 Preferred non-smoker mortality rates were introduced, thereby substantially lowering premiums for non-smokers and increasing premiums for smokers. A new money concept was developed, whereby the returns credited to the policy reserve were based on the yields available from the current investment of premium revenues. Previously, amounts credited to policy reserves were based on the company s portfolio average rates of return. Because new money rates could not be guaranteed for the duration of the contract, policies became variable or adjustable. Depending on current investment returns, the premiums and/or the amount of the benefits under the policy were adjusted. Companies also began offering an enhanced dividend option on their participating life insurance contracts. This option involved using the dividends to buy portions of one-year term coverage and paid-up additions. This effectively transformed the participating policy into a new money contract. Deregulation of Reserve Standards Before 1978, federal insurance legislation required that the superintendent of insurance prescribe the mortality and interest rate assumptions to be used by insurers in calculating their policy reserves. Typically, these were based on the Commissioners 1958 Standard Ordinary Mortality Table and an interest rate of between 3 and 4 percent very conservative assumptions. In 1978, the legislation was amended to shift the responsibility of establishing adequate policy reserves, including the underlying mortality and interest rate assumptions, to a valuation actuary appointed by the directors of the insurance company. The determination of policy reserves thus became much more flexible, and a great deal of reliance was placed on the professional judgment of the valuation actuary. The deregulation of reserves in 1978 paved the way for much of the product innovation over the next 15 years. In addition, as the competitive pressures escalated both between the insurance industry and other financial institutions and within the industry among companies competing for market share, policy reserves became considerably less conservative after This has resulted in significantly increased price competition in the life insurance marketplace. Tax System The 1969 tax reform for the insurance industry turned out to be a trial run for a massive reform of the entire income tax system, which was launched 31 For a more complete discussion of life insurance product developments in the late 1970s, see John A. Bowden, The Role of Life Insurance Products in Estate Planning Following the Federal Budgets of November 1981 and June 1982, in Report of Proceedings of the Thirty-Fourth Tax Conference, 1982 Conference Report (Toronto: Canadian Tax Foundation, 1983),
19 1524 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE with the release of a white paper in November The white paper sparked widespread public debate and exhaustive hearings before committees of both the House of Commons and the Senate. 33 This process culminated in 1971 with the introduction of Bill C-259, which contained 750 pages of detailed amendments to the Income Tax Act the largest income tax bill ever to be dealt with by the Canadian parliament. Reforms included the introduction of the tax on capital gains, a fundamental restructuring of the taxation of corporations and their shareholders, and modifications of resource incentives. Having just gone through the trauma of becoming subject to income tax for the first time, the life insurance industry was left relatively untouched by the 1971 tax reforms. In 1974, the government introduced a special $1,000 tax exemption for interest income earned by individuals in recognition of the adverse impact of inflation on savings. 34 The exemption was expanded in 1975 to include dividend income and in 1977 to include capital gains. With the IIT imposed at the corporate level, there was no easy way to extend the benefits of the exemption to individual savings through life insurance. This problem was the catalyst that precipitated major changes to the taxation of life insurance in Policy Holder Changes The March 1977 budget proposed two significant changes relating to the taxation of investment income earned inside life insurance policies. First, the IIT (imposed under part XII of the Act) was to be repealed. Explaining the proposed repeal, the minister of finance said: [W]hen the government introduced the $1,000 exemption for interest and dividend income, the balance between competing forms of savings may have been upset. Therefore, the Part XII tax will be repealed and the investment income on life insurance policies and annuities will be allowed to accumulate tax-free for the benefit of the policyholder. 35 The second change, intended as the quid pro quo for the IIT, was to tax the investment gain implicit in a life insurance policy upon the death of the insured in the same manner as it was taxed upon the surrender or maturity of the policy. The reaction of the life insurance industry to this second proposal was swift and violent. The proposal, variously dubbed the tax on death and the widows and orphans tax, was quickly withdrawn pending further 32 E.J. Benson, Proposals for Tax Reform (Ottawa: Department of Finance, 1969). 33 See Canada, House of Commons, Eighteenth Report of the Standing Committee on Finance, Trade and Economic Affairs Respecting the White Paper on Tax Reform (Ottawa: Queen s Printer, 1970) and Canada, Senate Standing Committee on Banking, Trade and Commerce, Report on the White Paper Proposals for Tax Reform Presented to the Senate of Canada (Ottawa: Queen s Printer, 1970). 34 SC , c. 26, section 70, effective for the 1974 and subsequent taxation years. 35 Canada, Department of Finance, 1977 Budget, Budget Document, March 31, 1977, 43.
20 TAXATION OF LIFE INSURANCE 1525 study. 36 Surprisingly, the government proceeded with the repeal of the IIT. As a result, after 1977 the investment income accumulated for the benefit of a policy holder was subject to tax only upon a disposition, surrender, or maturity of the policy other than on death. Another amendment arising from the 1977 budget included amounts received from a policy loan made after March 31, 1978 as proceeds of disposition of an interest in the policy. 37 The 1969 amendments did not deal specifically with policy loans. It was, and still is, an open question whether a policy loan is a loan in the strict legal sense. In some cases the arrangement may be a true loan made by the insurance company from its general funds and secured by the policy. In other cases, it may be merely an advance on the owner s interest in the policy, which the owner is under no obligation to repay. If a policy loan is not treated as a disposition, the owner effectively can defer the payment of tax until the policy is surrendered or matures. If the policy is left in force until death, tax is avoided altogether. The 1977 amendment was intended to block this perceived abuse. Changes to the segregated fund rules were also made in The original provisions introduced in 1969 proved not to achieve the objective of taxing such funds in the same way as if the funds were invested in an unincorporated mutual fund. The 1978 amendments deem a segregated fund of a life insurer to be a separate inter vivos trust. The annual income of the fund is deemed to be distributed to the policy holder as the deemed beneficiary of the trust. 38 These changes finally put segregated funds on an even footing with mutual fund trusts Company Changes By 1977, eight years after the introduction of income tax on life insurance companies, many cracks and anomalies had developed in the system. In an attempt to shore up the sagging structure, major changes were introduced, effective in In a memorandum to the industry in February 1978, the Department of Finance stated: The reserves available to life insurers under the income tax law in force to the end of were clearly excessive. 39 The main reason for this excessive level of policy reserves was the use of the net level premium method of calculation. Under this method, a constant proportion of each premium is set aside in the reserve. This does not recognize that the early premiums are used by the insurer to fund heavy front-end distribution and administrative costs. Since such policy acquisition costs are deductible for tax purposes as incurred, 36 Canada, House of Commons, Debates, October 20, 1977, SC , c. 1, section 74(5), amending subparagraph 148(9)(c)(ii) of the Act. 38 Ibid., section 74(2), amending subsection 148(3) of the Act and section 23(1), repealing paragraph 56(1)(k) of the Act. 39 Department of Finance memorandum, Transitional Rule for Policy Reserves of Life Insurers, February 1978, 1.
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