Adjusted Cost Basis of a Life Insurance Policy in Canada
Introduction
Adjusted cost basis is the most important number attached to a life insurance policy, and the one policy owners understand least.
It determines whether a surrender produces a taxable gain. It determines whether a policy loan is taxable. It determines the size of the capital dividend account credit when a corporate owned policy pays out. It determines the tax cost of transferring a policy between parties.
Despite this, most policy owners assume it equals the premiums they have paid. It does not, and the gap between the two generally widens every year the policy is held.
This article sets out how the figure is actually built under the Income Tax Act.
Where the Definition Sits
Adjusted cost basis is defined in subsection 148(9) of the Income Tax Act. The definition applies for the purposes of section 148 and related provisions.
The structure is a formula. A series of lettered additions is reduced by a series of lettered subtractions, producing the balance at any given time.
The formula is cumulative and runs from acquisition of the interest. It is recalculated continuously as events occur rather than at a fixed annual point.
The Additions
Several categories increase the figure.
The cost of acquiring an interest in the policy is added. This covers a purchaser who acquired an existing policy rather than taking out a new one.
Premiums paid by or on behalf of the policyholder are added. This is the component most owners are aware of, and it is only one of many.
Amounts previously included in income on a disposition of an interest in the policy are added. Where a policy loan produced a taxable policy gain, that gain increases the basis, which prevents the same amount from being taxed twice.
Repayments of policy loans made after March 31, 1978 are added, subject to a limiting calculation set out within the definition.
Certain historical and specialized amounts are also added, including a grandfathering amount relating to cash surrender value as at the first policy anniversary after March 31, 1977, and mortality gains in respect of certain annuity contracts and policies transferred to a spouse on death.
The Reductions
The subtractions are where the figure departs from premiums paid.
Proceeds of disposition the policyholder became entitled to receive are deducted. Every surrender, partial surrender and policy loan therefore reduces the basis.
The net cost of pure insurance is deducted annually. This is the single most significant reduction in most policies and is addressed separately below.
For policies issued after 2016, three further reductions apply. Premiums or cost of insurance charges relating to benefits other than the benefit on death are deducted. Certain death or disability benefits paid that reduce cash surrender value without terminating a coverage are deducted. And a formula amount applies on the termination of a coverage where a death benefit is paid under it.
Various other amounts are deducted, including amounts deducted under subsection 20(19) and the amount payable in respect of a policy loan as at March 31, 1978.
Net Cost of Pure Insurance
This component is the reason adjusted cost basis behaves counterintuitively over time.
Net cost of pure insurance is a prescribed amount, defined by regulation and determined by the insurer in accordance with the regulations. It represents the mortality cost of providing the coverage for the year.
It is deducted for each year, for interests in policies last acquired after December 1, 1982, in respect of taxation years commencing after May 31, 1985.
The amount is small in the early years, when the insured is younger and mortality risk is low. It grows as the insured ages, and in later years it can exceed the premiums being added.
The resulting pattern is predictable. Adjusted cost basis rises in the early and middle years as premiums outpace the mortality deduction, reaches a peak, then declines, and in many long held policies approaches nil.
Why the Pattern Matters
The decline has consequences in two directions, and they pull against each other.
For lifetime access, a declining basis is unfavourable. The policy gain on a surrender or policy loan is the excess of proceeds over basis, so the same withdrawal produces a larger taxable amount in year forty than in year fifteen.
For corporate owned policies at death, a declining basis is favourable. The capital dividend account credit is the death benefit less the adjusted cost basis, so a lower basis produces a larger tax free credit.
A corporation holding a policy purely for estate purposes and one holding a policy as an accessible asset are therefore pulling in opposite directions on the same number. Planning should acknowledge which objective is primary.
Policy Loan Interest
Interest on a policy loan interacts with the basis in a way that surprises most owners.
The definition of premium in subsection 148(9) includes interest paid after 1977 to a life insurer in respect of a policy loan, other than interest that is deductible under paragraph 20(1)(c) or (d).
Non-deductible policy loan interest therefore increases adjusted cost basis, because it is treated as a premium.
Deductible policy loan interest does not. The owner obtains a deduction instead.
What the Premium Component Excludes
Not every amount paid under a policy counts as a premium for this purpose.
The definition excludes the portion of amounts paid in respect of accidental death benefits, disability benefits, additional risk from insuring a substandard life, additional risk on conversion of a term policy, additional risk under a settlement option, and additional risk under a guaranteed insurability benefit, in specified circumstances.
A policy carrying a number of riders will therefore accumulate basis more slowly than the total of the payments made would suggest.
Partial Dispositions
Where only part of an interest is disposed of, the full basis is not applied against the proceeds.
Subsection 148(4) prorates the basis using a formula based on the proceeds relative to the cash surrender value, with a modified calculation for policies issued after 2016 that takes outstanding policy loans into account.
This is why a partial withdrawal can produce a taxable amount even where the total adjusted cost basis exceeds the amount withdrawn.
Obtaining the Figure
The practical point is that policy owners should not attempt this calculation themselves.
The insurer maintains the adjusted cost basis and determines the prescribed components, including net cost of pure insurance, in accordance with the regulations.
The figure should be requested from the insurer in writing before any transaction that depends on it, including a surrender, a policy loan, a transfer of ownership, or a capital dividend account calculation following a death claim.
It should be obtained as at the relevant date rather than as at the last policy anniversary, since intervening transactions will have changed it.
Common Mistakes
Several errors recur.
The most common is equating adjusted cost basis with premiums paid, which overstates it, often substantially, in a long held policy.
Another is assuming the figure only rises. It declines once the net cost of pure insurance exceeds the premiums being credited.
A third is calculating a capital dividend account credit on the full death benefit without deducting the basis.
A fourth is taking a policy loan in a later year on the assumption that the basis is where it stood a decade earlier.
Finally, owners of post-2016 policies sometimes apply the pre-2017 framework, missing the three additional reductions that apply to those contracts.
Conclusion
Adjusted cost basis is defined by formula in subsection 148(9) of the Income Tax Act. It is built from additions including the cost of acquiring the interest, premiums paid, prior income inclusions and policy loan repayments, reduced by subtractions including proceeds of disposition and the net cost of pure insurance.
Net cost of pure insurance is the component that makes the figure behave unexpectedly. It is deducted annually and increases with the age of the insured, so the basis typically rises, peaks, and then declines toward nil over a long holding period.
That decline increases the taxable gain on lifetime access while increasing the capital dividend account credit available to a corporation at death.
Policies issued after 2016 are subject to three additional reductions that do not apply to earlier contracts.
The figure is maintained by the insurer and should be requested in writing, as at the relevant date, before any transaction that depends on it.
Tax Partners can assist you in structuring your affairs properly and ensuring full compliance while optimizing your tax position.
This article is written for educational purposes.
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