RECENT TAX DEVELOPMENTS IMPACTING INSURANCE PLANNING

RECENT TAX DEVELOPMENTS IMPACTING INSURANCE PLANNING Kevin Wark, LLB, CLU, TEP President Conference for Advanced Life Underwriting (CALU) Toronto 2015 Ontario Tax Conference

Recent Tax Developments Impacting Insurance Planning Kevin Wark, LLB, CLU, TEP President, Conference for Advanced Life Underwriting Introduction There have been a number of important legislative developments and interpretations governing the tax treatment of life insurance policies and associated planning structures since the presentation by myself and Florence Marino at the 2013 Ontario Tax Conference. 1 This paper will discuss a number of these insurance related developments, including the final exempt test and policyholder tax legislation enacted in December, 2014; the implications of the new rules governing graduated rate estates and charitable giving; the grandfathering rules for LIA policies enacted in 2013; and recent Canada Revenue Agency ( CRA ) technical interpretations. 1. Exempt Test and Policyholder Tax Legislation In the 2012 Federal Budget the Department of Finance ( Finance ) announced plans to make technical changes designed to update and simplify the exempt test and policyholder taxation rules, as well as make technical improvements to the investment income tax (IIT) 2. Over the next two years Finance engaged in consultations with the insurance industry on the proposed changes and released two sets of draft legislation 3. The final legislation was enacted on December 16, 2014. 4 There continue to be ongoing discussions between the industry and Finance to clarify the legislation in preparation for its implementation in 2017. This section of the paper will provide a high level overview of the current exempt test and policyholder tax rules (which will generally continue to govern policies issued before 2016), and discuss how the final legislation will impact policies issued after 2016. Overview of the Current Policyholder Tax Rules 5 1 See Kevin Wark, Review of Proposed Changes to the Exempt Test Legislation, and Florence Marino, Life Insurance Planning for Individuals and Private Corporations, Canadian Tax Foundation - 2013 Ontario Tax Conference. 2 Canada, Department of Finance, 2012 Budget dated March 29, 2012. 3 Department of Finance release 2013-105 dated August 23, 2013 and a Notice of Ways and Means Motion dated October 10, 2014. 4 The final legislation was contained in Bill C-43 which received Royal Assent on December 14, 2014, and will apply to life insurance policies issued (or deemed to be issued) after December 31, 2016. 5 The current rules apply to policies last acquired after December 1, 1982 and are referred to in this article as the current policyholder tax rules or current rules. A policy will be treated as last acquired after December 1, 1982 if the policy is issued after that date, or a policy issued before December 2, 1982 has been transferred to an arm s length person. Further, subsection 12.2(9) of the Act will treat policies last acquired before December 2, 1982 similarly to policies last acquired after December 1, 1982 if certain policy transactions take place after December 1, 1982. 1 P a g e

Tax Treatment of Exempt Policies General Guidelines The Income Tax Act 6 provides a limited tax preference for exempt insurance policies by permitting a maximum prescribed level of accumulation within an insurance policy without subjecting the income earned on such accumulations to accrual taxation. 7 The intent is to allow a policyholder to accumulate value in the policy on a tax-deferred basis, which can be used at a later date to subsidize policy expenses and minimize the risk of the policy lapsing at older ages. As well, the death benefit received under an exempt insurance policy is not subject to taxation. However, if a policyholder disposes of a policy prior to death, the rules will capture and tax any gains realized by the policyholder. While these general guideline are easy to state in theory, the practical application of these rules, via the exempt policy definition, has resulted in very complex system that in reality only insurance companies can interpret and manage on behalf of their policyholders. a) The Exempt Test 8 The exempt policy definition is the means by which it is determined if the level of accumulation within an insurance policy has become so great that the accrual taxation rules should apply. 9 In other words, the rules try to delineate between a policy whose primary purpose is insurance protection (an exempt policy) and a policy whose primary purpose is investment accumulation (a non-exempt policy). Under the exempt test rules, the accumulating fund (AF) (savings element) of the actual policy is compared with the AF of a notional policy referred to as the exemption test policy (ETP). Where the AF of the actual policy at the time of issue and thereafter 10 remains below the AF of all the ETPs 11 deemed issued in respect of the policy, the actual policy will be an exempt policy and not subject to accrual taxation. The Regulations to the Act prescribe the various assumptions 12 and mechanics that must be used by an insurance company to determine and compare the AF of the actual policy with that of the policy s ETPs. In general terms, an insurance policy will be exempt provided its accumulating fund is no greater than that of a policy that endows at age 85 based on 20 equal premium payments. 13 The vast majority of 6 R.S.C. 1985, c.1 (5 th Supplement), as amended, hereinafter referred to as the Act. Unless otherwise stated, statutory references in this paper are to the Act. Note that all references to the Act and Income Tax Regulations in this section use the numbering in effect before December 16, 2014, unless stated otherwise. 7 These accumulations generally arise when premiums or deposits exceed the annual mortality and administrative expenses of the policy. This excess amount is invested by the insurance company and income is credited to the policy in a variety of ways. As discussed, income earned on accumulations within an exempt policy is not subject to accrual taxation. 8 See also Gail Grobe, The Exempt Test for Life Insurance Policies Parts I, II and III contained in 2009 and 2010 Insurance Planning, Volume 16. 9 Subsection 12.2 of the Act. 10 Regulation 306(1) of the ITR. 11 Ibid. Additional ETPs can arise if new insurance coverages are added to the policy. 12 For example, the interest and mortality rates used in determining the AF for the actual policy and the ETP. 13 See Regulations 306(3)(d)(ii), 307(1)(c) and 307(4) of the ITR. 2 P a g e

insurance policies that have been issued since December 2, 1982 have been designed to meet this definition and are therefore exempt policies. Insurance companies are required, on each policy anniversary, to test the policy to ensure that it is exempt on that policy anniversary and that it is reasonable to expect, having regard to a number of assumptions, that the policy will remain exempt on future policy anniversaries (referred to as the pretesting rule). 14 For flexible products such as Universal Life ( UL ), the pre-test has created practical difficulties in terms of confirming whether a policy will remain exempt on all future policy anniversaries. It has therefore become the industry s practice for insurance companies to contractually agree to take whatever action is possible so that such policies will continue to be exempt on each policy anniversary, in order to satisfy this test. 15 b) Additional Limits on Accumulations The Regulations to the Act contain additional checks and balances on the amount that can be accumulated within an exempt policy. For example, the amount that can be accumulated on a taxdeferred basis is dependent on the policy s death benefit, with the result that a policy with a growing death benefit will permit higher accumulations and tax deferred growth. Future increases in a policy s death benefit are therefore limited by providing that any increase in excess of 8 percent in a policy year will result in the deemed issue of a separate exemption test policy for the excess amount. 16 This new layer of death benefit will have less accumulation room than if it were part of the exemption test policy that was created when the original policy was issued. This effectively limits the ability to make a large deposit or premium payment to fund the increased death benefit. Another rule applies whether or not there is a change in the death benefit, and is designed to place limits on the size of deposits made to the policy after the policy has been in force for 10 years or longer. This is accomplished by comparing the AF of the actual policy on the tenth and every subsequent policy anniversary with the AF of the actual policy on the third preceding policy anniversary. If the ratio of the accumulating fund in the current year to the accumulating fund in the third preceding anniversary exceeds 250% (the so-called 250% test), the policy s ETPs are generally deemed to have been issued on the third preceding policy anniversary. 17 This re-dating of the policy s ETPs will reduce the amount that can be accumulated in the actual policy. The failure of the 250% test can be avoided by the policyholder withdrawing funds from the policy, unless the reserve component of the AF is the cause of the 250% failure. In situations where the policy has been funded at a minimum level, this effectively prevents the policyholder from making sufficient deposits to result in the policy being paid-up 18 at a 14 Regulation 306(1)(b) of the ITR. 15 This is typically accomplished by a combination of increases in death benefit and/or forced withdrawal of funds from the policy. 16 Regulation 306(3)(b) of the ITR. 17 Regulation 306(4)(b) of the ITR. 18 A paid-up policy is one that has sufficient cash values such that the premiums or cost of insurance can be funded now and in the future by the policy s internal values. In other words, the policyholder does not expect to make any further premiums or deposits to the policy to keep it in force. 3 P a g e

later date, and in effect treats policies (and policyholders) differently based on the funding pattern of the policy in its first 10 years. (d) Policy Dispositions Although deposits or premiums paid into an exempt policy are permitted to grow on a tax-deferred basis, such growth may become subject to tax if there is a disposition of the policy. 19 While this was also the case for policies last acquired before December 2, 1982 20, several changes were made as a result of the introduction of the current policyholder tax rules. One change relates to the determination of the adjusted costs basis ( ACB ) of an insurance policy. This is relevant as the difference between the proceeds of disposition 21 arising from the disposition of an interest in a policy and the ACB of that interest is reportable by the policyholder as a taxable gain. 22 In other words, on a disposition of an insurance policy, the ACB of the interest in the policy being disposed of can be received as a tax-free return of capital, while the excess amount becomes taxable. 23 The current rules introduced the concept of the net cost of pure insurance ( NCPI ) of a policy, which is designed to reflect the mortality costs of an insurance policy. 24 The NCPI of the policy at the end of the calendar year is deducted from the ACB of the policy, which over time will reduce the ACB of the policy to NIL. 25 Therefore, if policies are held for a long period of time and then disposed of prior to death, most or all of the proceeds received at that time will be taxable. Another change requires the pro-rating of the ACB of the policy on a partial disposition. 26 As a result, a gain can arise from a partial disposition even though the ACB of the policy exceeds the proceeds arising from the disposition of the interest in the policy. However, for policies issued before December 2, 1982, no gain would arise on a partial disposition if the proceeds did not exceed the ACB of the policy at that time. 27 19 A disposition is defined in section 148(9) of the Act and includes a partial or full surrender of the policy and the taking of a policy loan. However, it does not include the payment of a death benefit under an exempt policy. 20 See the discussion of the pre-december 2, 1982 rules in Appendix A. 21 Defined in subsection 148(9) of the Act. 22 Subsection 148(1) of the Act. 23 The ACB of a life insurance policy is also relevant in determining the credit to the capital dividend account (CDA) of a corporation from the receipt of life insurance proceeds (refer to the definition of CDA in subsection 89(1)). In this case a lower ACB is desirable as it increases the credit to the CDA, and in turn permits more of the death benefit to be paid out as a tax-free capital dividend (see subsection 83(2) of the Act). 24 The methodology for determining a policy s NCPI is set out in Regulation 308 of the ITR. 25 Paragraph L of the definition of ACB in subsection 148(9) of the Act. The reduction of a policy s ACB by its NCPI became effective for calendar years ending in a taxation year that begins after May 31, 1985. Therefore, for policies issued to individuals, the NCPI deduction commenced for calendar years beginning January 1, 1986. 26 Subsection 148(4) of the Act effective for partial disposition of policies last acquired after December 1, 1982. A partial disposition would include a withdrawal of cash from the policy. 27 Note that a policy dividend and policy loan is specifically excluded from the operation of subsection 148(4) and therefore no gain arises unless the dividend or loan exceeds the ACB of the policy at that time. 4 P a g e

Finally, the annuitization of a policy last acquired after December 1, 1982 will be treated as a disposition of the policy and the taxation of any policy gains will be triggered at that time. 28 Subsequent Tax Changes of Importance to the Insurance Industry The following is a brief review of other tax changes that occurred subsequent to the enactment of the current policyholder tax rules: (a) Capital Dividend Account Around the same time as the introduction of the exempt test rules the federal government announced changes to limit the ability of private corporations to pay out insurance proceeds to shareholders on a tax-free basis. The original proposals were subsequently modified and implemented through the introduction of the Life Insurance Capital Dividend Account (LICDA). 29 This is now of mere historical importance as the LICDA was repealed two years later, with the result that insurance proceeds are credited to a corporation s CDA and can be paid-out tax free to shareholders. 30 In a somewhat similar vein, but with much longer lasting impact, the so called stop-loss rules were introduced in 1995. A discussion of these rules is beyond the scope of this paper, but generally limit the carry-back of capital losses arising in an estate where corporate owned life insurance is used to facilitate a share redemption from the estate of a deceased shareholder. 31 (b) The Investment Income Tax (IIT) In 1987 the $1,000 investment income deduction was eliminated, sparking the reintroduction of a modified investment income tax to ensure that the investment income within an exempt policy is subject to a reasonable level of tax. 32 In effect, the IIT represents a minimum tax on the accumulating fund of an exempt policy and is effectively borne by the policyholder through increased policy charges and/or reduced investment returns. c) Single Premium Policies In the early 1990 s a small number of insurance companies marketed a short-pay UL policy by assuming an increasing death benefit under the policy, based on a narrow interpretation of the exempt test rule relating to 8% test, as discussed above. 33 The insurance industry reviewed this product design with Finance and recommended that the Regulations be clarified to prevent this interpretation. The 28 Subsection 148(6) provides that for policies last acquired before December 2, 1982, the annuitization of the policy does not result in proceeds of disposition and any policy gains are taxed as payments are received under the annuity. 29 S.C. 1980-81-82-83, c. 140, section 22. 30 Supra note 23. 31 Subsection 112(3.2) of the Act effective April 26, 1995. See also Florence Marino, Stop-Loss Provision Draft Legislation Released, (1997) 4 Insurance Planning 236. 32 Part XII.3 of the Act (sections 211 211.5). 33 Supra note 16. 5 P a g e

Regulations were subsequently amended to prevent indexed policies from benefiting from more advantageous tax treatment, with grandfathering for all policies issued before March 26, 1992. 34 Overview of Changes Effective for Policies issued after 2016 35 Exempt Test Changes a) AF Calculations There are significant changes to the calculation of the accumulating fund for ETPs. Instead of using the pricing basis of the actual policy, the insurance companies must use fixed assumptions for interest (3.5%) and mortality (Canadian Institute of Actuaries ( CIA ) 86-92 mortality table). 36 As well, for most ETP issue ages, an eight-year payment period is to be used instead of the current 20-year payment period with the assumption that the policy endows at age 90 (instead of age 85 under the current rules). 37 The exempt test rules have also been clarified to ensure the test continues to apply beyond age 90. 38 Similarly, the reserve element of the AF of the actual policy will no longer be based on the product pricing or cash value assumptions but will use fixed interest and mortality assumptions on the same basis as the AF of the ETP (3.5% interest and CIA 86-92 mortality table). 39 The reserve basis of the policy will change from the 1.5 year preliminary term methodology to net premium reserve 40 methodology. In addition, the cash value of the policy will be determined before surrender charges. 41 In comparison to the current rules, the AF of any ETP will generally be higher in the first ten years of the coverage (theoretically allowing higher deposits and more accumulation room during this period of time) but trending lower thereafter until age 90. On the other hand, the AF of the actual coverage will generally be higher at all coverage durations in comparison with the current rules. 42 The impact of these changes will be significantly greater for UL Level Cost of Insurance (UL LCOI) policies as surrender charges will now be ignored and the embedded reserve will be included in determining the 34 Amendments to Regulation 306 by SOR/94-4i5 (1994), Vol. 128, No. 12 Canada Gazette Part II 2431-32. 35 These rules generally only apply to policies issued after 2016, as well as to policies issued before 2017 that lose their grandfathering as discussed later in this article. Throughout this section references to policies issued after 2016 will also apply to policies issued before 2017 that lose their grandfathering. Note that all references in this section to the Act or Income Tax Regulations use the numbering that became effective on December 16, 2014, unless otherwise stated. 36 Regulation 1401(1)(c) and Regulation 1401(4) of the ITR. The mortality rates to be used for substandard and joint life policies is also clarified in Regulation 1401(4)(b)(i)(C) and (ii) respectively of the ITR. 37 Definition of interpolation time in Regulation 1401(3) of the ITR and endowment date in Regulation 310 of the ITR. 38 Definition of pay period in Regulation 310 of the ITR. 39 Supra note 36. 40 Definition of net premium reserve in Regulation 1401(3). 41 Regulation 1401(1)(c) of the ITR. It is anticipated that this will result in insurance companies re-evaluating the use of surrender charges since they provide no accumulation advantage to policyholders. 42 In combination, it is not expected that accumulation or deposit room will be enhanced significantly in the early years of a policy and may in fact for certain policies such as UL LCOI, be lower than under the current rules. 6 P a g e

AF of the actual policy. Single premium or very short pay policies will therefore no longer be possible under the new rules and it is expected that the minimum premium payment period, using conservative interest rate assumptions, will be in the range of eight years. With the AF of the ETP moving to lower values after approximately the tenth policy year, and the AF of the actual policy being generally higher through all policy durations, the net effect will be generally neutral in the first ten to twelve policy years and then a reduction in the maximum amount that may be accumulated over the remaining duration of the policy. It is difficult to provide a more detailed analysis as the overall impact will depend on the type of product, the policyholder s age and the expected funding pattern. For example, the impact will be more pronounced for UL LCOI life pay policies at younger ages and have less of an impact if premiums are paid over a shorter period of time. 43 It should also be noted that only a small percentage of policyholders pay premiums to achieve the maximum permitted accumulation room over the life time of the policy. As a result, in the majority of situations, policyholders will not experience any significant impact from these changes to the exempt test. There are a number of other changes designed to clarify the application of the rules to joint policies and multi-life policies 44, and the allocation of the policy fund value across policy coverages for the AF of the ETP. 45 The definitions also clarify the intended application to fixed premium policies (e.g., participating whole life, traditional non-participating whole life and term policies) and variable deposit products (e.g., UL). 46 One of the impacts of these changes is that adding coverage to an existing policy will create no greater deposit and accumulation room that buying a new stand-alone policy. 47 In summary, the various changes will harmonize the exempt test rules as they apply to various products and the types of coverages under those policies (single, joint, multi-life) and eliminate much of the differentiation that may currently exist in how the exempt test is being applied by various insurance companies. Other Exempt Test Rules As discussed above, the exempt test currently includes a rule which permits the policyholder to increase the death benefit of the policy by 8% annually to maintain the exempt status of the policy. 48 This rule will be retained for policies issued after 2016, but will apply at the coverage level rather than the policy level. 49 Applying this test at the coverage level may reduce the accumulation room of the policy as compared to the current rules. 43 For example, a policy that is designed to be paid-up in ten years. 44 This is accomplished by moving ETPs from a policy to a life insured basis in applying the exempt test. See the definition of coverage in Regulation 310 of the ITR. 45 Supra. 46 This is accomplished by the Regulations using terminology specific to these types of policies such as premiums or cost of insurance charges. 47 If coverage is added to a policy issued before 2017, it may also impact the grandfathered status of the entire policy as discussed below. 48 Regulation 306(3)(a) of the ITR. 49 Regulation 306(3)(b) of the ITR. 7 P a g e

As discussed above, there is also a pre-testing rule which requires the insurance company to ensure that the policy will continue to be exempt on all future policy anniversaries, based on certain prescribed assumptions. 50 For policies issued after 2016, the test will be modified to be a one-year pre-test, which requires the insurance company to project the policy values to the following policy anniversary, using reasonable assumptions and the most recent values used in calculating the AF of the policy and the AF of the ETPs without regard to any automatic adjustments (e.g., an 8% death benefit increase or withdrawals to keep the policy exempt) that would be made at the next policy anniversary to keep the policy exempt. 51 The projected values are to be used to calculate the AF of the policy and AF of ETPs, including the 8% and 250% tests and to perform the exempt test. The current 250% test will also be modified in two important respects, with these changes applying to policies issued before 2017 commencing after 2016, as well as to policies issued after 2016. The revised test will continue to apply to a policy starting in the 10 th or later policy anniversary. However, the ETPs of the policy will only need to be re-dated if it fails both of the following tests: The AF of the policy exceeds 250% of the AF of the policy on its third preceding policy anniversary, and If the policy is issued before 2017, the AF of the policy exceeds 3/20 of the AF of the ETPs issued in respect of the policy; or if the policy is issued after 2016, the AF of the policy exceeds 3/8 th of the AF of the ETPs issued in respect of the policy. If there is a failure of the 250% test, (i.e., both conditions are failed), the deemed issue date of each ETP issued in respect of the policy which has an issue date prior to the 3 rd anniversary preceding the current anniversary, will be reset to the 3 rd anniversary prior to the current anniversary. However, unlike the current rules, after a failure of the 250% test it will not apply again until the following seventh policy anniversary. 52 It is expected that this modification of the test (in particular postponement of the next re-test for a seven-year period) will help resolve the current problem where the 250% test prevents adequate prefunding of the policy, which in turn increases the chances of the policy lapsing in the future. 53 The Investment Income Tax 54 The IIT will be recalibrated in the following respects for policies issued after 2016: 55 The embedded reserve for UL LCOI policies will be included in determining the IIT base 50 Regulation 306(1)(b)(i) of the ITR. 51 Regulation 306(1)(b)(ii) of the ITR. 52 Regulations 306(6) and (7) of the ITR. 53 It should also be noted that the revised rules for determining the AF of the actual policy should result in fewer 250% failures, particularly for UL LCOI policies. 54 Supra note 32. 55 Regulations 1401(1)(c) and 1401(5) of the ITR. 8 P a g e

The policy reserve will continue to use the 1.5 preliminary term method based on pricing assumptions for the cost of insurance rates, including lapses for lapse supported products 56 Generally, the AF of the policy will equal the greater of (i) the net cash surrender value of the policy and (ii) the 1.5 preliminary term reserve plus any fund value not used to reduce the cost of insurance charges In general, the revised IIT formula will not impact most types of insurance policies. However, it will result in the increase of IIT payable on level cost of insurance policies and limited-pay UL policies. For example, the change in IIT on UL LCOI policies, if fully flowed through to policyholders, will have a material impact on COI rates at younger ages (in the range of 6-9%), gradually grading down at older ages (for example, 3% or less for insureds over the age of 60). There will also be an impact on level limited pay UL policies (whether on a level cost or yearly renewable term cost). 57 Life insurance issued before 2017 will generally be grandfathered from the IIT changes. See the discussion below in the section entitled Grandfathering Rules for more information. Section 148 and Other Changes a) Deemed Proceeds of Disposition 58 It is possible for an insurance company to issue a life insurance policy that separately covers more than one life insured (known as a multi-life policy ). 59 For example a corporation might apply for insurance on the lives of three shareholders for the purpose of buy-sell funding. Purchasing one policy covering all three lives, rather than separate policies on the life of each shareholder, often results in lower administrative expenses being charged by the insurance company. As is the case with any exempt insurance policy, amounts can be accumulated in a multi-life policy on a tax-deferred basis. A number of insurance companies permit the accumulated values under a UL multilife policy to be paid out on the death of each life insured. The Canada Revenue Agency ( CRA ) has accepted that the payment of the accumulated value on the death of a life insured (whether the policy is on a single life, joint life or multi-life basis) will be treated as a tax-free death benefit. 60 However, Finance is concerned that the ability to pay out the accumulated value of the total policy on each death creates the incentive to use a multi-life policy rather than separate policies in order to 56 The term lapse supported policies is defined in Regulation 1408(1) of the ITR. 57 While UL LCOI and limited pay products issued after 2016 will be subject to a higher IIT cost, this is intended to correct a deficiency in the current application of the IIT to these products. 58 Subsection 148(2) of the Act. 59 A multi-life policy must be distinguished from a joint life policy, where there is only one insurance coverage which is dependent on the death of one (joint first to die) or both lives (joint second to die). 60 Para (j) of the definition of disposition in subsection 148(9) of the Act. See also CRA TI 2000-0033885 dated September 11, 2000. 9 P a g e

convert what would otherwise be taxable income (if withdrawn from the policy), into a tax-free death benefit. New paragraph 148(2)(e) is meant to deal with this potential planning opportunity. It applies to a situation where an insurance death benefit is paid that results in the termination of the coverage but not the policy (for example, this rule does not apply to a payment on first death under a joint last-to-die policy since the coverage has not terminated). If the fund value benefit 61 that is paid out exceeds the maximum amount permitted in respect of that coverage, 62 a policyholder with an interest in the policy that gives entitlement (of the policyholder, beneficiary or assignee, as the case may be) to the excess portion is deemed to have disposed of a part of an interest for proceeds equal to that excess portion. This change may result in a portion of the benefit paid out of the policy s fund value on the death of an insured under a multi-life policy being taxable. It is important to note there are related changes under revised subsection 148(4) and the definition of ACB in subsection 148(9), as discussed below. b) Partial Dispositions Subsection 148(4) applies on the partial disposition (other than one arising from a policy dividend or policy loan) of a taxpayer s interest in a life insurance policy. With a partial disposition the ACB of the interest is pro-rated according to a formula in this subsection and this pro-rated ACB is used to determine if there is a taxable gain under subsection 148(1). Subsection 148(4) is amended for life insurance policies issued after 2016 and modifies the formula to use the policy s cash surrender value (less policy loans) rather than the AF of the policy. This change deals with a concern expressed by the industry that the new AF definition could result in the reportable income arising from a series of partial dispositions exceeding the reportable income on a full disposition. Another benefit is that the policyholder and his or her advisors will be able to determine the pro-rated ACB without having to access this information from the issuer of the policy. Subsection 148(4.01) is a new provision that complements changes made to the definition of proceeds of disposition discussed below. The overall purpose of these changes is to ensure that the partial disposition rules in subsection 148(4) cannot be avoided by first making a policy loan and then effecting a partial disposition of the policy to repay the policy loan using internal policy funds. Subsection 148(4.01) is designed to ensure that the ACB of the interest in the policy is properly adjusted to avoid the potential for double taxation of the same gain. In particular, subsection 148(4.01) deems a partial surrender that reduces the amount payable by the policyholder in respect of a policy loan to be a repayment of the policy loan immediately before the partial surrender takes place. This in turn will increase the ACB of the interest in the policy for purposes of determining any gain arising from the partial surrender. It should be noted that this result only will arise if the partial surrender is not otherwise considered to be a repayment of the policy loan and does not reduce the proceeds of disposition (i.e. the policy loan being repaid by the partial surrender was not originally used to pay a premium under the policy). 61 As defined in Regulation 1401(3) of the Regulations. 62 Under Regulation 306(4)(a)(iii). This amount is to be determined on the first policy anniversary on or following the date of death of the life insured under the coverage. 10 P a g e

Adjusted Cost Basis 63 The ACB of an interest in a life insurance policy is important in determining the taxable gain that might arise on the disposition of a policy. 64 The ACB of the interest is also relevant in determining the amount that will be added to the capital dividend account of a private corporation arising from the receipt of insurance proceeds. 65 The definition of ACB is a cumulative calculation involving a number of variables. The definition is being modified to take into account certain policy transactions including the repayment of policy loans; premiums or cost of insurance charges for ancillary benefits; capital disability or death benefits; and benefits on death resulting in the termination of coverage under a multi-life policy. The various changes to the ACB calculation are discussed below. Revised Variable E Current Variable E permits an increase in the ACB for the repayment of a policy loan in certain circumstances. Currently there is no increase in the ACB of the interest upon the repayment of a policy loan that was originally used to pay a premium under the policy and not otherwise reflected in the ACB of the policy. Such an increase will be permitted for policies issued after 2016, unless the repayment of the policy loan has previously been applied to reduce the proceeds of disposition as per the revised definition of proceeds of disposition (see below). In other words, the policy loan must be repaid with funds external to the insurance policy to obtain an ACB increase. New Variable M This amendment is to ensure that only premiums or COI charges that relate to the benefits on death 66 are ultimately included in the ACB calculation. It should also be noted that the term benefit on death includes an endowment benefit but excludes other ancillary benefits. As well, the current definition of premium in subsection 148(9) will not apply to policies issued after 2016. The net effect of these changes, for policies issued after 2016, is to ensure that only that portion of the premiums or COI charges relating to the death benefit remain as part of the ACB of the policy. 67 All other ancillary premiums or cost of insurance charges (e.g., disability, critical illness, waiver of premium, guaranteed insurability, and accidental death and dismemberment benefits) will be deducted from a policy s ACB. New Variable N Insurance companies currently offer life insurance policies which allow the accumulated value of the policy to be paid out on the death or disability of the life insured. 68 The insurance industry relies on specific exemptions under the definition of disposition to treat such amounts as a tax-free payment. 69 As a consequence, the payment of such benefits would not reduce the ACB of the policy. 63 Defined in subsection 148(9) of the Act. 64 Subsection 148(1) and paragraph 56(1)(j) of the Act. 65 Supra note 23. 66 As defined in Regulation 1401(3) of the ITR. 67 See definition of premium and Variable M of the definition of adjusted cost basis in subsection 148(9). Extra premiums for substandard or rated life insurance risks will also increase the ACB of the policy for policies issued after 2016. 68 Such policies are typically UL policies. 69 See note 60 for the tax treatment of death benefits arising from the payment of the fund value on death. See para (h) of the definition of disposition in subsection 148(9). However, in technical interpretation 2007-11 P a g e

However, for policies issued after 2016, Variable N is designed to reduce the ACB of a policyholder s interest in a policy upon the payment of a benefit on death or disability, where such payment is funded by the cash value of the policy and does not result in the termination of a coverage (e.g., a death benefit paid on the first death under a joint second-to-die policy 70 or a disability benefit under single/joint or multi-life coverage). The ACB reduction is equal to the greater of the amount by which the cash surrender value and the fund value of the policy 71 is reduced by the amount paid. New Variable O This provision is intended to reduce the ACB of an interest in a life insurance policy issued after 2016 in respect of any benefits paid whenever a benefit on death 72 has been paid under a coverage and the coverage has terminated, but the policy itself continues to be in effect. This provision will therefore apply to a multi-life policy (including a policy with a spousal or child term rider) where a death benefit has been paid and the coverage on that life has terminated. The ACB adjustment under Variable O consists of the following elements: [P x (Q+R+S)/T] U These elements may be summarized as follows: P = the ACB of the policyholder s interest immediately before the termination of that coverage Q= the fund value benefit paid in respect of that coverage on the termination R= the present value of the of the fund value of that coverage 73 S= the amount determined on that policy anniversary as the net premium reserve of that coverage 74 T= the amount determined on that policy anniversary as the net premium reserve of the policy based on prescribed assumptions 75 0257591E5 the CRA expressed reservations on the tax treatment of disability benefits that are linked to the investment income earned in the policy. 70 Note that the payment of a death benefit from the fund value under a multi-life policy issued after 2016 is governed by the rules in paragraph 148(2)(e) as well as Variable O of the definition of ACB discussed below. 71 As defined in Regulation 1401(3) of the ITR. The fund value of the policy is the total value of all investment accounts and therefore ignores surrender or other charges. 72 As defined in Regulation 1401(3) of the ITR. 73 Determined for purposes of Regulation 307 of the ITR on the last policy anniversary on or before the termination of the coverage, as if the fund value of the coverage at that time were equal to the fund value of the coverage on termination. 74 The amount determined under paragraph (a) of the description of C in the definition of net premium reserve in Regulation 1401(3) of the ITR in respect of the coverage, if the benefit on death under the coverage, and the fund value of the coverage, on that policy anniversary were equal to the benefit on death under the coverage and the fund value of the coverage on the termination. 75 The amount determined by the definition of net premium reserve in Regulation 1401(3) of the ITR in respect of the policy, if the fund value benefit under the policy, the benefit on death under each coverage, and the fund value of each coverage, on that policy anniversary were equal to the fund value benefit, benefit on death under each coverage and the fund value of each coverage, under the policy on the termination. 12 P a g e

U = The amount of ACB already allocated to a payment in respect of a fund value benefit under paragraph 148(2)(e) and subsection 148(4) (discussed above). Proceeds of Disposition 76 The definition of proceeds of disposition of an interest in a life insurance policy applies in determining the amount that is required to be included in income upon the disposition of the interest. The definition also contains detailed rules to deal with specific types of policy transactions such as the surrender or maturity of the policy, policy loans and dispositions on death. Paragraph (a) of the definition provides that the proceeds of disposition on the surrender or maturity of the policy is the cash surrender value of the policy less certain amounts, including an amount payable in respect of a policy loan. In effect, the amount of any outstanding loan reduces the proceeds of disposition and possible tax reporting, on the basis that the ACB of the policy has already been reduced upon the taking of the policy loan. However, Finance is concerned that the reduction in the proceeds on a partial disposition by the policy loan might permit planning to avoid a taxable gain that would otherwise arise on a partial disposition of the policy. The provision is therefore being amended to provide that, for policies issued after 2016 and where there has been a partial disposition of a policy, the specified amount by which the cash surrender value is reduced by the policy loan is only that portion of the policy loan that had been applied, immediately after the loan, to pay a premium under the policy. Please also refer to the discussion above relating to subsection 148(4.01). Net Cost of Pure Insurance 77 The NCPI is of importance in determining the ACB of an interest in a life insurance policy 78 as well as the collateral insurance deduction under paragraph 20(1)(e.2) of the Act. 79 The NCPI is meant to approximate the annual mortality risk charge under the policy and is calculated as the product of the probability of death in the year for the life insured (using a prescribed mortality table) multiplied by the net amount at risk in respect of the taxpayer s interest at the end of the year. Generally, the NCPI determined for an insurance policy will increase every year as the life insured grows older. For level pay insurance policies 80, this results in the ACB of the policy increasing in the early years (due to premium or deposit payments exceeding the NPCI deductions), but at later durations the ACB reducing to nil (due to the annual NCPI deductions exceeding the premiums or deposits paid into the policy). There are a number of changes in the NCPI calculation for policies issued after 2016: The annual mortality risk is to be determined using the Canadian Institute of Actuaries 1986-1992 mortality table; 81 76 Defined in subsection 148(9) of the Act. 77 Supra note 24. 78 The total of all annual NCPI charges will reduce the ACB of the policyholder s interest in a policy by virtue of Variable L in the ACB definition in subsection 148(9) of the Act. 79 The deduction cannot exceed the lesser of the premium paid and the NCPI determined for the policy in respect of the year. 80 For example, guaranteed whole life, participating life and UL LCOI policies. 81 Regulation 308(1)(b)A and Regulation 1401(4)(b)(i)(B) of the ITR. 13 P a g e

Generally, if the life insured is substandard, the mortality rates are to be adjusted to take into account the rating on the life insured; 82 Generally, if the policy is a joint policy insuring two or more lives, the joint mortality rates are to be derived based on the Canadian Institute of Actuaries 1986-1992 mortality table using the pricing methodology of the issuer of the policy; 83 Generally, the net amount at risk of a coverage at the end of the year is the difference between the benefit on death of the coverage at the end of the year and the net premium reserve of that coverage; 84 The implications of these changes will be as follows: 1. The mortality rate for standard lives will in most cases be lower due to the use of the more recent mortality table, and the net amount at risk for any specific coverage will generally be lower. This will generally result in higher ACBs in earlier policy durations, with it taking longer for the ACB to be reduced to nil as a result of the NCPI adjustment, in relation to the current rules. This will be beneficial from a tax perspective where a policy is surrendered, as the higher ACB will reduce the amount of the policy gain. However, the higher ACB will also reduce the CDA credit where insurance proceeds are received by a private corporation. 85 As well, the deduction permitted under paragraph 20(1)(e.2) will be lower until such time as the NCPI amount equals or exceeds the premium paid in the year. 2. The annual mortality rate for substandard policies may be higher, which could result in a higher collateral insurance deduction under paragraph 20(1)(e.2) than would be available under the current rules. The additional NCPI amount determined for a substandard life insured will generally be offset by the inclusion of the extra premium charge for a substandard life in determining the ACB of the policy. Tax Treatment of Prescribed Annuity Contracts The tax rules relating to pay-out (also known as immediate) annuities require the reporting of any payments received, less the capital portion of the payment, where the annuity qualifies as a prescribed annuity contract (PAC). 86 Regulation 300 contains rules for determining the capital element of the payment under a pay-out annuity. Where the payments under the annuity depends upon the survival of the annuitant (a life annuity ), Regulation 300(2) contains rules for determining the expected number of capital payments under the contract based on a prescribed mortality table. 82 Regulation 308(1)(b)A and Regulation 1401(4)(b)(i)(C) of the ITR. 83 Regulation 308(1)(b)A and Regulation 1401(4)(b)(ii) of the ITR. 84 Regulation 308(1)(b)C of the ITR. The net premium reserve is subject to certain adjustments. Most companies currently use the policy s cash surrender value to determine the net amount at risk, which in most cases will be lower than the net premium reserve of the policy. 85 The CDA arising from shorter duration term insurance (i.e. Term 5 and Term 10) will not be significantly impacted by these changes. 86 Paragraphs 56(1)(d) and 60(a) of the Act. The requirements for a PAC are established in Regulation 304 of the ITR and are generally only available where the owner of the annuity is an individual or certain types of trusts. PACs are not subject to the accrual reporting rules under subsection 12.2(1) of the Act. 14 P a g e

Effective for PACs issued after 2016, the mortality table used for determining the capital portion for payout annuities be updated from the 1971 Individual Annuity Mortality Table 87 to the Annuity 2000 Basic Mortality Table 88. The new mortality table, which reflects the lengthening of life expectancies since 1971 (approximately 1.5 2 years at older ages), will result in a higher portion of each payment being taxable under a PAC. There are grandfathering provisions for annuities issued before 2017, which are discussed below. The rules for PACs issued after 2016 have also been amended to recognize substandard annuities in determining the capital portion of payments under the annuity. 89 Under these rules, the age to be used is the annuitant s rated age at the time the annuity first qualifies as a prescribed annuity. The net effect of this change will be to reduce the taxable portion of the payments that would otherwise arise from using the actual age of the annuitant. A third change relates to who can own prescribed annuities. Currently testamentary trusts (including spousal testamentary trusts) can acquire a prescribed annuity contract provided certain conditions are met. However, changes to the rules effective for prescribed annuities issues after 2015, will generally prevent testamentary trusts from acquiring a prescribed annuity. 90 However, an annuity issued after 2015 may qualify for prescribed annuity status if the holder is a qualified disability trust 91 in the year in which the annuity was issued. The term of such an annuity must not extend beyond a fixed term or a fixed period of time defined by reference to the life of an individual who is an electing beneficiary 92 of the trust for the taxation year in which the annuity is issued. 93 Grandfathering Rules a) The Exempt Test and Section 148 Rules (i) Life Insurance Policies Last Acquired before December 2, 1982 For policies last acquired before December 2, 1982, the grandfathering rules enacted when the exempt test rules were first introduced in 1982 will continue to apply. 94 Therefore, such policies will be treated as having been last acquired after December 1, 1982 95 if there is a prescribed premium paid after December 1, 1982 and the policy fails the exempt test; or there is a prescribed premium and prescribed 87 As published in Volume XXIII of the Transactions of the Society of Actuaries. 88 As published in the Transactions of the Society of Actuaries, 1995-96 Reports. 89 A substandard annuity is generally available to annuitants with health issues that are expected to reduce that person s life expectancy, and in turn will result in higher payments under the annuity. A substandard annuity is not recognized under the current rules for purposes of determining the capital element of the annuity payment, with the result that any increase in payments due to the rating will be fully taxable to the owner of the annuity. 90 A spousal testamentary trust can still qualify to be the holder of a prescribed annuity by virtue of Regulation 304(1)(c)iii)(a)(II) of the ITR. 91 Defined in subsection 122(3) of the Act and includes testamentary trusts. 92 Ibid. 93 Regulation 304(1)(c)(iii)(A), 304(1)(c)(iv)(B)(II)2 and 304(1)(c)(iv)(C)(III) of the ITR. 94 Subsection 12.2(9) of the Act, which has been repealed but still applies to life insurance policies last acquired before 1990. 95 And consequently subject to the exempt test and policyholder tax rules for policies issued before 2017. 15 P a g e