How Policy Loans Are Taxed in Canada
Introduction
A policy loan is one of the simplest ways to access the cash value of a permanent life insurance policy. The policy owner contacts the insurer, requests an advance, and receives funds.
The administrative simplicity is misleading. Under Canadian tax law a policy loan is not treated as borrowing at all. It is treated as a partial disposition of the policy, and it can produce taxable income in the year it is taken.
Policy owners are frequently surprised by a T5 slip arriving after what they understood to be a loan. The rules below explain why that happens and when it does not.
A Policy Loan Is a Disposition
Subsection 148(9) of the Income Tax Act defines a policy loan as an amount advanced by an insurer to a policyholder in accordance with the terms and conditions of the life insurance policy.
The same subsection defines disposition for life insurance purposes, and that definition expressly includes a policy loan made after March 31, 1978.
This is the structural point. Because the transaction is a disposition, subsection 148(1) applies and a taxable policy gain can arise.
A policy loan is also distinct from ordinary borrowing in a practical sense. The insurer cannot compel repayment. However, where the loan together with accrued interest exceeds the cash surrender value, the policy will terminate unless a portion is repaid.
Calculating the Proceeds
The amount treated as proceeds is not simply the amount advanced.
Paragraph (b) of the definition of proceeds of the disposition in subsection 148(9) sets the proceeds of a policy loan made after March 31, 1978 at the lesser of two amounts.
The first is the amount of the loan, excluding any part applied immediately after the loan to pay a premium under the policy as provided for under the terms of the contract.
The second is the amount by which the cash surrender value immediately before the loan exceeds the total balances outstanding at that time of any policy loans in respect of the policy.
The exclusion for amounts applied to premiums matters in practice. Where a loan is taken and immediately applied to pay a premium on the same policy, that portion does not form part of the proceeds and no taxable amount arises on it.
The Income Inclusion
Once proceeds are determined, subsection 148(1) requires the policyholder to include in income the amount by which those proceeds exceed the adjusted cost basis of the interest immediately before the disposition.
Where the adjusted cost basis exceeds the proceeds, no amount is included. This is why loans taken in the earlier years of a policy, when adjusted cost basis is still relatively high, frequently produce no tax.
Where the proceeds exceed the adjusted cost basis, the excess is a policy gain. It is included in income in full as ordinary income, not as a capital gain.
A Worked Illustration
Consider a policy with a cash surrender value of $20,000 and an adjusted cost basis of $5,000, with no outstanding policy loans. The owner takes a policy loan of $12,000.
The proceeds are the lesser of the loan amount of $12,000 and the excess of cash surrender value over outstanding loans of $20,000. The proceeds are therefore $12,000.
The policy gain is $12,000 less the adjusted cost basis of $5,000, producing an income inclusion of $7,000.
The adjusted cost basis is then adjusted. It is increased by the $7,000 included in income and reduced by the $12,000 of proceeds, leaving a balance of nil.
That final figure is the important one. With an adjusted cost basis of nil, any further amount accessed from the policy is fully taxable.
Repayment and the Deduction Under Paragraph 60(s)
Where a policy loan that produced an income inclusion is later repaid, paragraph 60(s) permits a deduction in the year of repayment.
The deduction is available to the extent of the amount previously included in the policyholder’s income in respect of that loan. In the illustration above, repaying the full $12,000 would support a deduction of $7,000.
The repayment also restores adjusted cost basis. Element E of the adjusted cost basis formula in subsection 148(9) adds amounts repaid in respect of a policy loan after March 31, 1978, subject to a limiting calculation.
Two features of the deduction deserve attention.
The CRA confirmed at the 2022 CALU roundtable that no carry forward is available under paragraph 60(s). Where the deduction in the year of repayment exceeds the taxpayer’s income for that year, the excess is lost.
The CRA also confirmed that the deduction is not tied to a particular source of income or to a particular place, as it falls within subdivision E.
This creates a timing risk. A policyholder who incurs a large inclusion in one year and repays in a later year with little income may be unable to use the full deduction.
Interest on a Policy Loan
Interest charged on a policy loan is a separate question from the loan itself.
Interest may be deductible under paragraph 20(1)(c) or (d) where the borrowed funds are used for the purpose of gaining or producing income from a business or property. The use of the funds governs, not the fact that the borrowing came from an insurer.
There is an additional procedural requirement. The insurer must verify the policy loan interest charged in the year, which is done on Form T2210, Verification of Policy Loan Interest by the Insurer.
Where interest is not deductible under those paragraphs, it is treated differently. 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 deductible interest. That treatment increases the adjusted cost basis of the policy.
Capitalized Interest
Where interest is not paid in cash but is instead satisfied by the insurer issuing a new policy loan, the treatment depends on deductibility.
The CRA addressed this in a 2016 technical interpretation. Where the policy loan proceeds were used to earn income such that the interest is deductible under paragraph 20(1)(c) or (d), capitalizing the interest by way of a new policy loan results in a further disposition.
Where the interest is not deductible under those paragraphs, the capitalized interest instead constitutes a premium under the policy for the purposes of subsection 148(9).
Policy owners who allow interest to accumulate should be aware that the accumulation is not tax neutral in the first case.
Comparison With a Collateral Loan
A collateral arrangement produces a different result at the time of borrowing.
Where the owner borrows from a third party lender and assigns the policy as security, the definition of disposition excludes an assignment of an interest for the purpose of securing a debt or loan other than a policy loan.
No policy gain arises on that assignment. This is the structural reason collateral lending appears in planning built around accessing cash value.
The comparison is not one sided. A collateral loan involves a third party lender, external interest costs, lending terms that can change, and the lender’s right to call the loan. A policy loan involves none of those, and the insurer cannot demand repayment.
The choice between them should be made on the full picture rather than on the tax treatment alone.
Common Planning Mistakes
Several errors recur with policy loans.
The most frequent is assuming a loan cannot be taxable because it is a loan. The Act treats it as a disposition regardless of the label.
Another is taking a large loan in a later policy year without first confirming the current adjusted cost basis, which has typically declined as the net cost of pure insurance accumulates.
A third is repaying a loan in a low income year and losing the benefit of the paragraph 60(s) deduction, which cannot be carried forward.
Finally, some owners claim interest deductions without obtaining Form T2210 from the insurer, leaving the claim unsupported.
Conclusion
A policy loan is a disposition under subsection 148(9) of the Income Tax Act, not borrowing in the ordinary sense. The proceeds are the lesser of the loan amount, excluding any portion applied immediately to pay a premium, and the excess of cash surrender value over outstanding policy loans.
Where those proceeds exceed the adjusted cost basis, the excess is a policy gain included in income in full.
Repayment supports a deduction under paragraph 60(s) to the extent of the amount previously included in income, and restores adjusted cost basis. The CRA has confirmed that no carry forward is available where the deduction exceeds income in the year of repayment.
Interest may be deductible under paragraph 20(1)(c) or (d) depending on the use of the funds, supported by Form T2210. Non-deductible policy loan interest is treated as a premium and increases adjusted cost basis.
The adjusted cost basis should be confirmed with the insurer before any policy loan is requested.
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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