Exempt vs Non-Exempt Life Insurance Policies in Canada

Introduction

Canadian tax law draws a line between life insurance that is primarily protection and life insurance that is primarily an investment vehicle.

That line is the exempt test. A policy that stays on the protection side of it is an exempt policy, and the growth inside it is not taxed year by year. A policy that crosses the line is non-exempt, and its growth becomes subject to annual taxation.

Virtually every permanent policy issued in Canada today is exempt. Insurers design their products to remain onside and build in administrative measures to keep them there.

That near universal compliance is precisely why many policy owners have never considered the question. The rules only become visible when something goes wrong, and by then the tax consequence has usually already occurred.

The Statutory Framework

The definition of exempt policy is found in section 306 of the Income Tax Regulations, which applies for the purposes of subsection 12.2(11) of the Income Tax Act.

Certain contracts are carved out of the definition entirely. These include annuity contracts, LIA policies, and deposit administration fund policies.

The test operates on each policy anniversary. On that date, the accumulating fund of the policy, determined without regard to any policy loan, must not exceed the total of the accumulating funds of the exemption test policies issued at or before that time.

Accumulating fund is itself a defined term, set out in section 307 of the Regulations for the purposes of sections 12.2 and 148 of the Act.

The Exemption Test Policy

The exemption test policy is a hypothetical benchmark contract. It does not exist in the real world and the policy owner never sees it.

The Regulations deem a separate exemption test policy to be issued alongside the actual policy. The accumulation permitted in the real policy is then measured against the accumulation in that benchmark.

The benchmark is defined by two main attributes, the pay period and the endowment date, both set out in section 310 of the Regulations.

For an exemption test policy issued in respect of a life insurance policy issued before 2017, the pay period is generally the twenty year period starting on the date of issue. Where the insured had attained age 75 at that date, it is a ten year period.

For an exemption test policy issued in respect of a coverage under a life insurance policy issued after 2016, the pay period is generally eight years.

The endowment date moved in the same reform. For pre-2017 policies it is generally the later of ten years after issue and the first policy anniversary on or after the insured would attain age 85. For post-2016 coverages the benchmark endows at a later age, reflecting increased life expectancy.

One further structural change applies to post-2016 contracts. The exemption test policy is issued in respect of each coverage under the policy rather than in respect of the policy as a whole.

The Effect of the 2017 Changes

The revised rules took effect January 1, 2017. The shift from a twenty year pay period to an eight year pay period, combined with the later endowment date, altered the shape of the permitted accumulation line rather than simply raising or lowering it.

The practical effect is more room in the earlier policy years and less room over the longer term.

That outcome was not neutral across product types. Designs built specifically to maximize long term accumulation under the prior rules, particularly level cost of insurance universal life, were affected more significantly than designs oriented toward guaranteed values.

Supporting Rules

Two further rules sit alongside the main test.

The first is commonly called the 8% rule. Where an increase in the death benefit is necessary to keep a policy exempt, the full death benefit may be increased by up to 8% annually. Under the post-2016 rules this adjustment applies at the level of the individual life coverage.

The second is the 250% test. It is an anti-avoidance measure directed at policies that are funded lightly in early years and then heavily funded later. It compares the accumulating fund on a policy anniversary against a multiple of the accumulating fund three years earlier, and it generally applies from the tenth policy anniversary onward.

Under the post-2016 rules, a policy must also have a material level of funding before it can fail the 250% test, which narrowed its application.

Timing and Grace Provisions

The Regulations include provisions that soften the mechanical operation of the test.

A policy that is exempt on its first policy anniversary is deemed to have been exempt from the time of issue until that anniversary.

A policy that ceases to be exempt on a policy anniversary, other than by conversion into an annuity contract, is generally deemed to be exempt on that anniversary. This allows a corrective adjustment before the consequence crystallizes.

For policies issued after 2016, an additional forward looking condition applies. It must be reasonable to expect that the test will be met on the next policy anniversary, determined without reference to automatic adjustments built into the policy for the purpose of maintaining exempt status.

What Happens If a Policy Is Non-Exempt

Where a policy fails the test and becomes non-exempt, the consequence is annual accrual taxation under section 12.2 of the Act.

The policyholder must include in income, on the anniversary day of the policy, the amount by which the accumulating fund exceeds the adjusted cost basis.

This happens every year, whether or not the policy owner has taken anything out of the policy. There is no realization event and no cash received to fund the resulting tax.

The broader tax advantage of permanent insurance is therefore removed, while the costs of the insurance structure remain.

Grandfathering and How It Is Lost

Policies issued before January 1, 2017 are generally grandfathered under the prior exempt test rules.

That status is valuable, because the earlier rules permit more accumulation over longer holding periods. It is also easier to lose than most owners realize.

Subsection 148(11) of the Act sets out when a pre-2017 policy is treated as issued after 2016. This occurs at the first time after 2016 at which term insurance under the policy is converted to permanent life insurance within the policy.

It also occurs where insurance is medically underwritten after 2016 and added to the policy, other than where the underwriting is done to obtain a reduction in premium or cost of insurance rates.

Insurance paid for with policy dividends, and insurance that is reinstated, are excluded from this rule.

The practical consequence is that routine policy service requests can carry a tax effect entirely unrelated to the reason for the request.

Common Planning Mistakes

Several errors recur in this area.

The most frequent is assuming the exempt test is the insurer’s problem alone. The insurer monitors it and will generally act to preserve exempt status, but the tax consequence of failure falls on the policy owner.

Another is requesting a policy change on a pre-2017 contract without advice, and converting a grandfathered policy into one governed by the post-2016 rules.

A third is overfunding a policy on the assumption that more deposits always produce more tax sheltered growth. Beyond the permitted line, the insurer must either refuse the deposit or adjust the policy.

Finally, some owners of older policies have never confirmed which set of rules governs their contract, which makes any planning built on it unreliable.

Conclusion

The exempt test separates life insurance that is treated as protection from life insurance treated as an investment. It is set out in section 306 of the Income Tax Regulations and operates by comparing the accumulating fund of the actual policy against that of a hypothetical exemption test policy.

The rules were revised effective January 1, 2017. The benchmark pay period moved from twenty years to eight, the endowment date moved later, and the test now applies at the coverage level for post-2016 contracts.

The consequence of failing the test is annual accrual taxation under section 12.2, calculated on growth the policy owner has not received in cash.

Policies issued before 2017 remain under the prior rules, but subsection 148(11) sets out circumstances in which that status is lost, including conversion of term insurance to permanent coverage within the policy.

Owners should confirm which rules govern their contract before requesting any change to 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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