CORPORATE INSURANCE

Collateral Insurance

When are life insurance premiums tax deductible?

Life insurance premiums are, for the most part, not deductible for income tax purposes. This is understandable given that insurance proceeds are tax free. One exception to the general rule is where insurance is used as collateral for a loan from a financial institution. In most cases, the insurance is issued on the life of a key shareholder.

BASIC REQUIREMENTS

The rules governing collateral insurance may be summarized as follows:

The policy must be assigned to a “ restricted financial institution ” (such as a bank, trust company, or life insurance company) in the course of borrowing from that institution.

Interest on the loan must be deductible to the borrower, i.e., the funds must be used for a business or investment purpose. No deduction is available if the insurance secures a loan that is used for personal purposes, such as a home mortgage, or if it secures an unused line of credit.

The collateral assignment of the life insurance policy must be required by the lender as a condition of the loan, and should be clearly reflected in the loan documentation. If a purported requirement is in reality a mere accommodation to the borrower by the lender, no deduction is permitted.

In order for the deduction to be available, the borrower must also be the owner of the life insurance policy. For example, no deduction is available where a corporate-owned life insurance policy is used to secure a personal loan to the shareholder.

If these conditions are not satisfied, no deduction is available.

DEDUCTIBLE AMOUNT

Where the above conditions are met, the borrower may deduct the lesser of the premiums payable by the borrower in the year and the net cost of pure insurance (NCPI) under the policy, provided that the deductible amount must be adjusted so that it relates to the amount owing from time to time during the year. For example, if the face amount of the policy exceeds the loan amount in the year, the deduction must be prorated accordingly.

This provides deductibility for any type of policy (term or permanent) that meets the above requirements. Canada Revenue Agency ’ s (CRA’ s) position is that premiums paid from the internal policy values of participating whole life policies are considered premiums for this purpose, as they are contractually stipulated and thus “ payable ” in accordance with the legislation.On the other hand, amounts paid from the cash value of universal life policies do not qualify, as such policies do not have a stipulated premium.

A policy ’ s NCPI reflects an annual mortality charge provided in a table prescribed in the Income Tax Regulations. This table was updated for policies issued after 2016 as part of the new exempt test rules introduced at that time. The new table reflects the fact that people are living longer, which means that in most cases the NCPI will be lower for post-2016 policies. The NCPI for any given policy will be available from the insurer.

CAPITAL DIVIDEND ACCOUNT CREDIT

Where the borrower/policyholder is a private corporation, the corporation will, in most cases, be named as beneficiary of the policy. On death, the insurer will typically issue a cheque jointly to the beneficiary and the lending institution, at which point the parties are free to determine and divide their respective entitlement to the proceeds. In that case, despite the collateral assignment, the full amount of the proceeds less the adjusted cost basis of the policy will be credited to the corporation ’ s capital dividend account (CDA). This credit is available even though all or a portion of the proceeds were used to repay outstanding indebtedness. The legal basis for this is that the proceeds were

‘‘ constructively received’’ by the beneficiary, then used to repay the indebtedness.

CREDITOR INSURANCE

Banks and other lending institutions typically use creditor insurance as a means of protecting business and other loans. In most cases, the financial institution itself will be named beneficiary of the policy and will apply the proceeds against outstanding debt.

At one time, the CRA had taken the position that in these circumstances no CDA credit was available, as the borrowing corporation was not the beneficiary of the policy. However, that position changed after the CRA was unsuccessful in several tax court cases, particularly the 2010 case of The Queen v. Innovative Installations. The Tax Court of Canada ruled that proceeds paid to the lending institution were constructively received by the borrower and therefore eligible for a CDA credit. The Federal Court denied the CRA’ s appeal and it appears that the CRA has accepted this result.

While the tax treatment of creditor insurance and conventional insurance for corporate borrowers may be aligned as a result of this decision, significant differences exist between the two in terms of policy features. In particular, creditor insurance is typically much less flexible and cost effective than a conventional insurance policy. Compare the two types of coverages before making any decisions.

GLENN STEPHENS, LLB, TEP, FEA, is the vice-president, planning services at PPI Advisory and can be reached at gstephens@ppi.ca

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