2016-0658641E5 Policy loan interest

Principal Issues: What are the tax implications of capitalized policy loan interest?

Position: General comments provided.

Reasons: Based on legislation and previous positions.

Author: Danis, Sylvie
Section: 148(1), 148(9)

XXXXXXXXXX                                                                                                                               2016-065864
                                                                                                                                                       Sylvie Danis
May 31, 2017

Dear XXXXXXXXXX:

Re:  Policy loan interest

This is in response to your letter dated June 2, 2016 and further to our telephone conversation on July 14, 2016 (XXXXXXXXXX/Danis). We apologize for the delay in responding to your letter.

In your letter, you express concern about the gain to be reported from the capitalization of interest on a policy loan on a life insurance policy. You are concerned about the fairness of the income tax legislation regarding life insurance policies. You note that the amount borrowed together with accrued interest is a debt you owe to the insurer and will be deducted from any payout on the policy if still unpaid at death. You suggest the amount calculated by your insurer and reported on your T5 information slip should instead be taxed in your insurer’s hands.

Our comments

This technical interpretation provides general comments about the provisions of the Income Tax Act (the Act) and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R7, Advance Income Tax Rulings and Technical Interpretations.

Under the Act, the savings accumulated in a life insurance policy are generally taxable unless the policy is exempt and they are paid as part of a death benefit to a named beneficiary. In broad terms, an exempt policy is a policy that is primarily designed to fund a death benefit, rather than one designed to be an investment and savings vehicle. Even if a policy is exempt, the accumulated savings are taxable to the policyholder if it is disposed of prior to the death of the insured.

The taxation of insurance products can be complex due to the wide variety of products available in the marketplace, many of which are structured to meet individual preferences and needs.

Disposition and gain

Generally, when a policyholder disposes of an interest in a life insurance policy, the policyholder is required to include in computing income a gain to the extent that the proceeds of the disposition of the interest in the policy exceed the adjusted cost basis (ACB) of that interest immediately before the disposition. The full amount of the gain is included in computing income of the policyholder pursuant to paragraph 56(1)(j) and subsection 148(1) of the Act.

Subsection 148(9) of the Act defines a disposition of an interest in a life insurance policy and includes a policy loan made after March 31, 1978. A policy loan is defined in subsection 148(9) of the Act as an amount advanced by an insurer to a policyholder in accordance with the terms and conditions of the life insurance policy.

Proceeds of the disposition

The term proceeds of the disposition of an interest in a life insurance policy is defined in subsection 148(9) of the Act and generally means the amount of the proceeds that the policyholder is entitled to receive on the disposition. Where the disposition is the result of a policy loan, the proceeds of the disposition are the lesser of the following amounts:

a) the amount of the loan, other than the portion of the loan used to pay a premium under the policy, as provided for under the terms and conditions of the policy, and

b) the amount, if any, by which the cash surrender value of the policy before the loan was made exceeds the total of the balances outstanding at that time of any policy loans in respect of the policy.

ACB of an interest in a life insurance policy

The ACB of a policyholder's interest in a life insurance policy is determined at any particular time by a formula under subsection 148(9) of the Act. In very general terms, the ACB will be the amount by which the cash premiums paid by the policyholder, and any income in respect of the policy that has previously been reported for tax purposes exceeds the net cost of pure insurance (NCPI) under the policy.

Furthermore, the proceeds of the disposition in respect of a policy loan will reduce the ACB and a gain resulting from a policy loan will increase the ACB. Note that policy loan repayments that were not deductible under paragraph 60(s) of the Act (as described below) will be added to the ACB in some circumstances, to a maximum of the proceeds of the disposition in respect of the loan.

Net Cost of Pure Insurance

Section 308 of the Income Tax Regulations (the Regulations) sets out the rules for calculating the NCPI of a taxpayer's interest in a life insurance policy. The NCPI represents the cost the policyholder has paid to be covered by insurance during the time that he or she has held the policy and as such reduces the amount that can be returned to the policyholder on a tax free basis on disposition of the interest in the policy.

Policy loan repayments

Where a policyholder repays an amount that has been included in income as a gain with respect to a policy loan, paragraph 60(s) of the Act permits a deduction in respect of the repayment of the policy loan. In general terms, the deduction in respect of the repayment is restricted to the amount by which the gains required to be included in income from policy loans exceed the amounts deductible in previous years in respect of the policy loan repayments. Essentially, if a policy loan results in a gain, a deduction for a repayment will be permitted under paragraph 60(s) of the Act, to the extent of the gain.

Capitalization of policy loan interest

Where the proceeds of a policy loan are used for the purpose of gaining or producing income such that the interest on the policy loan is deductible by the policyholder under paragraph 20(1)(c) or (d) of the Act and the interest is satisfied by the insurer issuing a new policy loan equal to the amount of the interest, the capitalization of the policy loan interest results in a disposition pursuant to paragraph (b) of the definition of disposition in subsection 148(9) of the Act.

Where the ACB of the policy is nil immediately before the capitalization of policy loan interest and the interest is deductible, the amount required to be included in income with respect to the capitalized interest and reported on a T5 information slip as required by section 217 of the Regulations is the amount of the interest capitalized.

Where the interest on a policy loan is capitalized and the interest is not deductible by the policyholder under paragraph 20(1)(c) or (d) of the Act, this interest represents a premium under the policy as described in paragraph (a) of the definition of premium in subsection 148(9) of the Act.

In calculating the gain, if any, on a disposition resulting from a policy loan as discussed above, the proceeds of the disposition do not include the amount of the loan that is used to pay a premium under the policy. The result is that there is no income inclusion by the policyholder and no impact on the ACB of the policyholder's interest in the policy in circumstances where non-deductible interest on a policy loan made in accordance with the terms and conditions of the policy is satisfied by way of an additional policy loan to the policyholder.

Life insurance policies issued after 2016

Recent amendments to the Act have modified a number of aspects of the rules relating to the tax treatment of life insurance policies other than annuity contracts. Such amendments include changes to the determination of whether a policy is an exempt policy, the determination of what types of transactions give rise to a disposition of an interest in a policy, and the determination of the tax treatment of a disposition of an interest in a policy (having regard to both the ACB of the interest and its proceeds of the disposition). These amendments apply principally with respect to life insurance policies that are issued after 2016. While an explanation of these amendments is beyond the scope of this letter, further information can be found on the Department of Finance website at www.fin.gc.ca.

T5 - Statement of Investment Income

The insurer with whom the policy is held is required to report the amount of a gain on the policy on a T5 information slip issued to the policyholder where there is a disposition for tax purposes. As such, a policyholder can obtain information from the insurer on how it calculated the proceeds of the disposition, the ACB and any gain on the disposition. Unfortunately, we are unable to confirm the amount of the gain you have to report in your 2013 to 2015 income. The calculations generally require information that is available only in the insurer's accounts.

The Canada Revenue Agency is responsible for administering the tax legislation enacted by Parliament, while the Department of Finance Canada is responsible for developing and evaluating federal income tax policy and amending the Act and the Regulations. If you have concerns about the fairness of the provisions of the Act regarding life insurance policies, you can write to the Tax Policy Branch of the Department of Finance Canada at 90 Elgin Street, Ottawa, Ontario  K1A 0G5.

We trust our comments will be of assistance. If you have any questions regarding the above, please do not hesitate to contact Sylvie Danis at (613) 670-9047.

Yours truly,

Jenie Leigh
Manager
Financial Institutions Section
Financial Industries and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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