New rules for life insurance

March 2016

New tax rules for life insurance policies will become effective on January 1, 2017. In most cases, the

tax benefits under the new rules will be reduced compared to policies issued pre-2017. If you are

considering the purchase of life insurance as part of your estate plan that means you should act

soon to avoid falling under the new regime.

The changes are intended to modernize the tax rules for life insurance, which were last revised in

1982. Since then, people are living longer, interest and inflation rate conditions have changed and a

vast array of new insurance products have emerged

The most significant revisions involve modifications to the regulations used to determine the

maximum amount that can be invested to satisfy the exempt test

for life insurance policies. Tax-

exempt life insurance products are often used for estate planning purposes. One of the biggest

changes is that post-2016 policies will have less tax-exempt room over the long run, resulting in

lower funding room and a reduced tax-free benefit on death—with the impact felt most by

universal life insurance policyholders.

In general, policies issued before January 1, 2017 will be “grandfathered” and will continue to

follow the current exempt test and policyholder taxation rules. However, there are certain triggers

that could remove the grandfathering status of an in-force policy. For example, if life insurance

coverage is added to the policy, with medical underwriting that occurs after 2016, the policy will no

longer qualify for grandfathering. Also, if term insurance is converted into permanent insurance

after 2016, the grandfathering will cease.

What are the key changes to the rules?

Corporate-owned life insurance

One significant change relates to corporate-owned life insurance and the amount that will get added

to the capital dividend account (CDA) on the death of the shareholder. This is important since the

amount in a CDA can be distributed tax-free to shareholders.

e.g., universal life insurance

A policy is exempt where the internal growth of the cash value (i.e., investment income attributed to the

policy) is not subject to annual accrual taxation. Virtually every policy issued in Canada is structured so that

the policy growth falls within the parameters required to be an exempt policy.

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For policies issued after 2016, an insurance policy's annual net cost of pure insurance will generally

be lower. This change will ultimately alter the adjusted cost base (ACB) of the insurance policy and

will result in lower additions to the CDA.

If you are considering a corporate-owned life insurance policy, perhaps to assist with the buy-out of

shares under a shareholders’ agreement, consider acquiring the policy before the end of 2016.

Using life insurance policies as collateral for loans

Life insurance policies with a cash surrender value (such as universal and permanent life policies)

are often used as collateral to provide funding for business or investment purposes. This is often

referred to as "leveraging" the life insurance policy. One advantage is that, where the policy is

assigned to the financial institution as a condition of the loan, a portion of the insurance premiums

may be deductible. The amount deductible is based on the lower of the premium paid in the year

and the net cost of pure insurance in respect of the year.

Under the new rules, where life insurance policies are used as collateral for a loan, a reduced

percentage of premiums paid will generally qualify for a tax deduction.

Insured annuities

Insured annuities can be a suitable investment strategy for older investors who have a significant

amount of non-registered funds which they don’t want to put at risk. They are looking for a steady

income stream, but they want to leave an estate for their children or grandchildren, and current

GIC rates are too low.

The insured annuity involves the purchase of a life annuity to generate a guaranteed income for life.

A permanent life insurance policy is then acquired with a death benefit equal to the amount

invested in the life annuity. The annual net after-tax yield from the annuity is higher than could be

earned in a GIC and is guaranteed for life. On death, the annuity income ceases and the original

capital is returned to the estate as a life insurance death benefit.

The new rules will result in an increase in the taxable portion of annuity income payments, which

will reduce their tax effectiveness. As such, if you are interested in an insured annuity, you should

consider a pre-2017 acquisition to take advantage of their current tax-efficiency.

Conclusion

If you or your business require life insurance products as part of your overall investment portfolio,

or if you need to put life insurance in place to meet other requirements, we would be pleased to

work with you and your insurance advisor before the changes take place to help you maximize your

tax benefits and meet your business objectives.

Paragraph 20(1)(e.2) of the Income Tax Act

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