The 2014 Federal Budget introduced major life insurance taxation changes that received Royal Assent (Bill C-43) on December 16, 2014, but will only begin to take effect as of January 2017. Due to these changes, a review of insurance requirements by the end of 2016 would be advisable for many taxpayers.

The Exempt Test
The exempt test rules for life insurance policies are being modernized to reflect more recent mortality experiences, to provide standardization across insurance companies and products and to take into account the new products that have emerged in the marketplace over the last 30 years, such as universal life and level cost of insurance. These rules exist to ensure that the favourable tax treatment of exempt policies are not available to policies that are mainly investment vehicles with only an ancillary insurance element.

Changes to the “exempt test” will reduce many of the tax advantages available. Policies issued prior to 2017 will be grandfathered, and retain a larger window for cash accumulation and tax sheltering than will be available on policies issued after 2016.

Investments through such exempt policies are exempt from accrual taxation and provide significant benefits. This is particularly true for policies owned by corporations, as investments outside the policy would be subject to non-active business tax rates.

Changes to the Adjusted Cost Basis (ACB)
It is also important to note that the investment fund portion of a life insurance policy also forms part of the death benefit which may become an addition to the capital dividend account (CDA). A second major factor for policies issued post-2016 will be the impact on the CDA of corporately owned policies.

full death benefit will not always be CDA - discuss with insurer

It is often assumed that the CDA will equal the full balance received on the death of the insured shareholder. However, because of these changes, a smaller portion of the death benefit will add to the CDA. This will require more corporate equity be withdrawn as taxable dividends.

The addition to the CDA is the death benefit (Proceeds), less the ACB of the policy. The ACB is generally the total premiums paid less the net cost of pure insurance (NCPI). Specifically, the calculation of the NCPI is changing such that it will take significantly longer for the ACB to decline to zero. This change will result in a much lower CDA addition for many years after issuance of the policy.

On the other hand, consider the impact of the common scenario where an individual cashes in a policy prior to death. In this case, the taxable component will be the Proceeds (cash received), less the ACB. Since the ACB will generally be higher in post-2016 issued policies, the taxable component will be less. In general, the owner will have access to increased cash values for a longer period, because of the slower decline of the ACB.

The ACB of Term insurance is also being increased on post-2016 contracts.

Grandfathering
As indicated above, policies in place before January 1, 2017 will generally be grandfathered. However, some alterations to such policies will result in loss of grandfathering. Increases in the amount of insurance where medical evidence is required or Term insurance conversions after 2016 will not qualify as pre-2017 grandfathered policies.

an insurance review this summer

Conclusion
It can take a considerable amount of time (from weeks, to even months) to implement an insurance policy. Reviewing existing coverage to assess the need for action some time before the end of 2016 is a matter of considerable urgency.

Thanks to Gary Clark of Clark & Arsenault Advisory in Edmonton, AB for this information.