How To Tax A Life Insurance Policy On A Policy In The United States

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1 Taxation of Life Insurance Policy Loans and Dividends Introduction Policyholders are required to include in income any gains realized upon the disposition of all or a portion of their interest in a life insurance policy (subsection 148(1) of the Income Tax Act (the "Act")). Dispositions include a full or partial surrender of a policy, a policy loan made after March 31, 1978, the maturity of a policy, an absolute assignment of a policy, and the payment of policy dividends (paragraph 148(2)(a) and definition of "disposition" in subsection 148(9) of the Act). This Tax Topic is intended to explore in detail two types of dispositions: the taking of a policy loan and the payment of policy dividends. In particular, it will discuss the treatment of these transactions for tax purposes. For a discussion of other dispositions, see the Tax Topic entitled "Dispositions of Life Insurance Policies". Changes to policyholder tax rules relating to exempt life insurance policies were included in Bill C-43 which received Royal Assent on December 16, This Tax Topic does not reflect the future changes to policyholder tax rules that will take effect January 1, 2017 for policies issued after For a summary of the future changes see the Appendix to the Tax Topic entitled The Exempt Test. Calculation of Taxable Policy Gains and the ACB of a Policy A taxable policy gain occurs when the proceeds of disposition exceed the adjusted cost basis (ACB) of the policy. The ACB is therefore the base value from which any taxable policy gain is measured. The ACB changes with certain transactions in respect of a policy, as outlined in the definition of "adjusted cost basis" in subsection 148(9) of the Act. Eligible premiums paid will generally increase the ACB of the policy. (Note that the term eligible premiums as used throughout this Tax Topic refers to premiums as defined in 148(9) of the Income Tax Act). (Premiums for certain benefits such as an accidental death benefit, a disability benefit, or additional risk for substandard life, conversion privileges or guaranteed insurability are not considered to be "premiums" for income tax purposes for policies last acquired after December 1, For details refer to the definition of premium in 148(9) of the Income Tax Act. ) For policies last acquired after December 1, 1982, the ACB is reduced by the "net cost of pure insurance" ("NCPI") for calendar years ending subsequent to May 31, NCPI is a measure of the pure mortality expense, taken from the Canadian Institute of Actuaries (CIA) Mortality tables.

2 As discussed below, taking a policy loan will generally reduce the ACB, while repayment of a policy loan will generally increase the ACB. Dividends paid under a participating policy will reduce ACB; but if the dividends are used to pay an eligible premium, purchase additional insurance under the policy or repay a policy loan, the ACB will generally not be reduced. Tax Treatment of Policy Loans A policy loan is defined in subsection 148(9) as an amount advanced by an insurer to a policyholder in accordance with the terms and conditions of the life insurance policy. Although these advances are referred to as policy loans, at law they are actually advance payments of a policyholder's entitlement under the policy. A policy loan taken after March 31, 1978 triggers a disposition of an interest in a life insurance policy for tax purposes. The proceeds of disposition will be the lesser of (i) the amount of the loan other than the part of the loan used to pay an eligible premium and (ii) the excess of the cash surrender value of the policy over the balance outstanding of any previous policy loan(s) (as per the definition of "proceeds of the disposition" in subsection 148(9) of the Act). This limits the proceeds of disposition to the amount of the cash surrender value of the policy, the CSV ceiling, and avoids double taxation (for example where all or part of the loan is taken against accumulated dividends). Even where the proceeds of disposition is fully offset by a premium payment, there may still be a policy gain if a portion of the premium is not an eligible premium. (See discussion of policy loan interest and automatic premium loans below). The proceeds of disposition are compared to the ACB of the policy immediately before the loan is taken, and a taxable policy gain will result if the proceeds of disposition are greater than the ACB of the policy. The proceeds of disposition in respect of the policy loan reduce the ACB of the policy. Any taxable policy gain is added to the ACB of the policy. If a policy loan is repaid in whole or in part with external funds, and at the time the loan was taken the proceeds from the policy loan exceeded the ACB (producing a taxable policy gain) then the repayment (up to the policy gain previously included in income), is deductible by the policyholder from income under paragraph 60(s) of the Act. The portion of the repayment in excess of the deductible amount i.e. the amount in excess of the policy gain previously reported (but limited to the original proceeds of disposition) would be added to the ACB The policyholder will be advised of the amount eligible for deduction as a consequence of the repayment by way of a Loan Credit Letter provided by the insurance company. If a policy loan is repaid in whole or in part and no amount of the policy loan had been taxed previously, then the policy loan repayments increase the ACB (just as the proceeds of the policy loan had reduced the ACB when taken out). The increase to the ACB is limited to the amount of the original proceeds of disposition. Policy Loans Outstanding at Death If the life insured under a policy dies and a policy loan is outstanding on the policy, the death benefit paid is reduced by the amount of the policy loan. CRA takes the view that no deduction under paragraph 60(s) is available. Their issue seems to be that the person who had the income inclusion as a result of obtaining a policy loan (the policy owner) is different from the person who constructively repays the policy loan by way of a reduced death benefit from the policy (the policy beneficiary who is the policy owner s estate or an heir). 2

3 In technical interpretation # C6, dated October 9, 2009 CRA was asked to consider a situation in which Mr. A was the owner and life insured under a life insurance policy. In a previous year Mr. A obtained a policy loan and included a policy gain in respect of that loan. CRA s responded as follows (confirming its prior interpretation , dated June 17, 1999): The deduction provided in paragraph 60(s) of the ITA applies only to the taxpayer who included an amount as a policy loan in his income and made a repayment of the said loan. No amount can be deducted in the final return of Mr. A pursuant to paragraph 60(s) of the ITA because the loan was not repaid at his death. There is no legislative provision allowing an estate or an heir to deduct an amount as a repayment of a policy loan when the policyholder has already included an amount in computing his income in respect of this loan. It should be noted that where a private corporation is the beneficiary of a life insurance policy with an outstanding policy loan at death, the credit to the capital dividend account would reflect the death benefit proceeds received net of the policy loan outstanding minus the ACB immediately before death (which would have reflected a reduction by the policy loan previously taken). See CRA technical interpretation # C6 dated October 8, Policy Loan Interest The treatment of policy loan interest depends on whether or not the interest is paid or capitalized and whether or not the interest has been deducted under 20(1)(c) for tax purposes. Policy Loan Interest that HAS NOT been deducted under 20(1)(c) If non-deductible policy loan interest is paid, it is considered an eligible premium (paragraph (a) in the definition of premium in subsection 148(9) of the Act) and is therefore an addition to the ACB of the policy. If non-deductible policy loan interest is capitalized (i.e. it is added to the policy loan balance) the unpaid interest is considered to be a disposition and is treated as a new policy loan and the payment of an eligible premium at the same time. The proceeds of disposition for a policy loan that is used to pay an eligible premium are nil (subparagraph (b)(i) in the definition of proceeds of the disposition in subsection 148(9) of the Act). As a result no gain arises as a result of capitalizing policy loan interest that is not deducted under 20(1)(c). Although eligible premiums paid normally increase the ACB of the policy, eligible premiums paid by way of a policy loan do not increase the ACB (element B in the definition of adjusted cost basis in subsection 148(9) of the Act excludes amounts referred to in subparagraph (b)(i) in the definition of proceeds of disposition ). Therefore, capitalized loan interest (that has not been deducted) does not increase (or decrease) the ACB of the policy. Similarly, when policy loans that represent capitalized interest are repaid, there is no adjustment to ACB for a repayment of capitalized policy loan interest (element E of the definition of proceeds of the disposition in subsection 148(9) adds loan repayments to the ACB of a policy). However the amount added under E cannot exceed the proceeds of the disposition in respect of that loan. Since the capitalized interest was not included in the proceeds of the disposition when it arose, it does not increase the ACB of the policy when it is repaid. (Confirmed in technical interpretation # E5). It would seem that the result of these rules is that if a client makes a series of partial payments to repay a policy loan, the payments will affect ACB until an amount equal to the principal portion of the policy loan is repaid. Any further repayments (which essentially represent the repayment of capitalized interest) will not affect ACB. Policy Loan Interest that HAS been deducted under 20(1)(c) If the policy loan proceeds are invested by the policyholder and earns income from a business or property (i.e. meets the deductibility requirements for interest under paragraph 20(1)(c) or paragraph 20(1)(d) of the Act), obtaining a completed form T2210 from the insurer will allow the policyholder to deduct the interest from income. Regulation 4001 specifies that the amount of interest must be 3

4 verified by the insurer on form T2210 no later than the last day on which the taxpayer is required to file his return of income for the taxation year. If this verification does not occur on a timely basis policy loan interest may not be considered interest for purposes of paragraph 20(1)(c) or (d).) If deductible policy loan interest is paid, it is not considered an eligible premium (paragraph (a) in the definition of premium in subsection 148(9) of the Act ) and therefore is not added to the ACB of the policy. As noted above, if non-deductible policy loan interest is capitalized (i.e. it is added to the policy loan balance) the unpaid interest is considered to be a disposition for tax purposes and is treated as a new policy loan. The proceeds of disposition for a policy loan generated by the capitalization of deductible interest is not reduced by interest capitalized since the interest is not considered an eligible premium. Therefore, the proceeds of the disposition in this case will equal the capitalized interest, and a taxable policy gain will result if the capitalized interest is greater than the ACB of the policy (subject to the CSV ceiling). (Confirmed in technical interpretation # E5). If policy loans related to capitalized interest that was deductible are repaid, then the portion of the repayment not greater than the policy gain previously included in income is deductible by the policyholder under paragraph 60(s) of the Act. The portion of the repayment in excess of the deductible amount would be added to the ACB of the policy (unless the CSV ceiling came into play when the interest was capitalized). Automatic Premium Loans Similar to the capitalization of non-deductible interest, an automatic premium loan (i.e. a policy loan advanced to pay a premium) generally has no effect on the ACB since this transaction also consists of a premium and a loan at the same time. The proceeds of disposition for the loan are reduced by any amount used to pay an eligible premium and as a result, an automatic premium loan will generally not produce taxable income. Similarly, when policy loans advanced to pay premiums are repaid, there is no adjustment to the ACB of the policy for the repayment. The Treatment of Dividends for Tax Purposes Policy dividends trigger a deemed disposition of an interest in the insurance policy under paragraph 148(2)(a). The proceeds of the disposition for a policy dividend are deemed to be the amount of the policy dividend less any amount used to pay an eligible premium or to repay a policy loan. If the proceeds of the disposition under paragraph 148(2)(a) are less than the ACB of the interest in the policy immediately before that time, the proceeds simply reduce the ACB and the policy dividend does not result in a policy gain. However, if the proceeds of the disposition exceed the ACB of the interest in the policy, then the dividend minus the ACB (before the disposition) represents the taxable gain. In this case, the ACB is reduced by the proceeds of the disposition and is increased by the taxable gain. The result of these rules is that generally policy dividends used in internal policy transactions (for example, to pay premiums, to purchase paid-up additions or term insurance added to the basic coverage, or to repay policy loans) will have zero proceeds under the deemed disposition rule under paragraph 148(2)(a). In these cases, the policy dividend has no impact on the ACB because there are no proceeds and there is no policy gain. (Note however that a policy gain may arise where some of the premiums paid are not eligible premiums for tax purposes.) 4

5 Conclusion Policy loans and the receipt of dividends are common transactions in respect of life insurance policies. It is important to understand the tax consequences of such transactions, as they can result in significant tax liability to the unwary policyholder. Last updated: February 2015 Tax, Retirement & Estate Planning Services at Manulife writes various publications on an ongoing basis. This team of accountants, lawyers and insurance professionals provides specialized information about legal issues, accounting and life insurance and their link to complex tax and estate planning solutions. These publications are distributed on the understanding that Manulife is not engaged in rendering legal, accounting or other professional advice. If legal or other expert assistance is required, the service of a competent professional should be sought. This information is for Advisor use only. It is not intended for clients. This document is protected by copyright. Reproduction is prohibited without Manulife's written permission. Manulife, the Block Design, the Four Cubes Design, and strong reliable trustworthy forward-thinking are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license. 5