February 17, 2016

Corporate Insurance – New Exempt Test Rules

Changes to the exempt test rules for life insurance policies were passed into law in December 2014, effective for policies issued after 2016. These changes were overdue, given that the previous rules were enacted in the early 1980s, before universal life (UL) policies assumed any prominence in the Canadian marketplace. Given this background, these changes, not surprisingly, have their greatest impact on UL policies, particularly those with level cost of insurance (LCOI) charges. Let’s examine the details.



The key purpose of the exempt test is to calculate the amount that is permitted to accumulate within an insurance policy on a tax-sheltered basis. Two key changes may cause significant reductions in the tax sheltering capacity of LCOI policies: the exclusion of surrender charges and the inclusion of the “embedded reserve.” The latter represents the part of the reserve within LCOI policies that is not available to the policyholder on surrender. While the recognition of this reserve will cause a loss of sheltering ability for LCOI policies, the changes create a more level playing field with other types of insurance policies, such as participating whole life, whose reserves were already being reflected under the pre-2017 rules.



The amount of any life insurance proceeds received by a private corporation, less the policy’s adjusted cost basis (ACB) to that corporation, is added to the corporation’s CDA. Amounts credited to the CDA can be distributed as tax-free capital dividends to the shareholders. The ACB of a life insurance policy is determined by a number of factors, the most important of which are premiums paid, which increase the ACB, and the net cost of pure insurance (NCPI), which reduces the ACB. The NCPI is determined using a mortality table prescribed by the Income Tax Regulations. After the policy has been in force for a number of years, the impact of the NCPI is a declining ACB that may eventually be reduced to zero. The new rules prescribe an updated mortality table for calculating the NCPI. Given improved mortality experience, the NCPI will, in most cases, be a lower amount than is currently the case. This means for most types of policies, the ACB will stay higher for a longer period of time. Depending on issue age and other factors, it will take from seven to 17 years longer for LCOI products to reach a zero ACB than under the current rules. The impact is even greater for LCOI policies, however, because of other changes that bring the calculations more in line with other products. This will typically result in lower CDA credits, and higher tax liabilities on dividends paid to shareholders, where corporate-owned policies are subject to the new exempt test rules.



While the updated ACB calculation negatively impacts the CDA calculation, it has a beneficial effect on the taxation of such policy dispositions as surrenders, withdrawals, and policy loans. In those circumstances, the difference between the proceeds of disposition and the policy’s ACB is included in income. With a higher ACB, under the new rules the taxable income on policy dispositions will be correspondingly reduced.



Where a life insurance policy is assigned as collateral for certain loans, a policyholder may deduct the lesser of the policy premium and the NCPI. The basic requirements are as follows:

  • The loan must be from a financial institution;
  • Interest on the loan must be deductible as an expense incurred to earn investment or business income; and
  • The policy owner and borrower must be the same person/entity. As discussed above, the NCPI for policies issued after 2016 will be lower in most cases, which in turn will reduce the collateral term deduction.



Policy holders may benefit significantly from having policies subject to the pre-2017 rules, which will motivate many to take action in 2016. The new rules will apply to policies issued after 2016, but some clarification is still needed as to whether, for example, grandfathering will be available for a policy issued in December 2016 but settled in January 2017. The prudent approach will be to ensure, where possible, that new policies are settled in 2016. Policies issued prior to 2017 will become subject to the new rules on the happening of certain events. For example, where a pre-2017 term insurance policy is converted to a permanent policy in 2017 or later, the policy will become subject to the new rules. It is therefore critical to ensure that, where appropriate, conversions take place before 2017. Grandfathering will also be lost where additional insurance is added to a pre-2017 policy that requires new medical underwriting. Policy changes of this nature should take place in 2016 where possible.

GLENN STEPHENS, LLP, TEP, is the vice-president, planning services at PPI Advisory