On January 1, 2017, new rules affecting the taxation of life insurance will come into effect under the Income Tax Act. These rules were introduced in 2012 and received Royal Assent in December 2014, but were given a grace period for implementation due to their significant effects on life insurance policies. On January 1, 2017 this grace period will end and the rules will come into full force. 

These new changes, however, will have only a minor effect on life insurance policies created prior to 2017. Policies enacted prior to 2017 will generally be grandfathered in under the old legislation. However, older insurance policies will lose their grandfathered status if fundamental changes to the policy occur. If you have any plans to change your life insurance coverage in the future, we highly recommend that you consult the team at Kelly Santini LLP to discuss how these changes may affect your policy and estate plans. 

The Ministry of Finance has stated that these legislative changes are an attempt to modernize the tax consequences of life insurance because the factual realities behind life insurance assumptions, such as how long an individual will live, have changed dramatically since the law was last amended.

There are several ways in which the legislation changes life insurance policies. 

1. There is a revised definition of the Exempt Test Policy benchmark;
2. The prescribed assumptions behind the Accumulating Fund (AF) of the Exempt Test Policy will change;
3. There will be revisions to the 8% rule and the 250% test; and
4. There are changes to the formula for the Adjusted Cost Base (ACB) of a life insurance policy.

Each of these changes is discussed in greater detail below.

A revised definition of the Exempt Test Policy (ETP) benchmark 

For tax purposes, a life insurance policy is either considered exempt or non-exempt. If the policy is considered exempt, then the investment earnings that are associated with the cash value of the policy will not be subject to annual taxation. In addition, the death proceeds are received tax-free upon the death of the insured. As such, exempt policies are particularly beneficial to policy holders.

When calculating the taxes due under it, every life insurance policy is compared to a hypothetical benchmark policy called the Exempt Test Policy (ETP). As long as the taxpayer’s yearly savings component of the life insurance policy remains below the ETP, the policy will remain exempt from tax. Currently, the ETP is based on a $20-pay endowment policy that will pay out at the age of 85. However, once the new legislative changes take effect, the ETP will be based on an $8-pay endowment policy at age 90. The effect of this change is that the life insurance holder will get additional funding room in the policy’s early years and a reduction in the later years of the insurance policy. 

Prescribed assumptions behind the Accumulating Fund (AF) of the ETP

The Accumulating Fund (AF) is used to measure the savings elements of both the ETP and the actual policy in question. Previous to these changes, each insurer had his or her own pricing or cash value assumptions that they used to measure the AF of the ETP. The new legislative changes make the assumptions behind the AF calculations uniform. 

In addition to this, the new legislation also changes how the AF for each individual policy is measured by creating a new reserve method for calculating the AF. This new reserve method, called the Net Premium Reserve (NPR) could have a significant impact on Level Cost of Insurance (LCOI) Universal Life (UL) policies. Specifically, these new rules could cause a reduction in the funding room of the policy over the lifetime of the policy. These rules have a similar, but much less severe, impact on more traditional types of insurance.

Revisions to the 8% rule and the 250% test

The 8% rule currently states that the full death benefit of an insurance policy may be increased by up to 8% annually if the increase is necessary for keeping the policy an exempt policy. 

Under the new rules, this increase can only occur at a life coverage level rather than at the full death benefit level. As a result, this new change could result in less funding room for some policies.

The 250% test states that after the 10th year, the AF of a policy cannot grow more than 250% in three years. If it exceeds this amount, then the policy fails as an exempt policy. This rule was created as a way to prevent policy owners from intentionally underfunding a policy in the early years in order to create additional funding room for the future years.

Under the new legislation, in order to fail the 250% test, a policy must also have a material level of funding. This means that the AF of the policy must be more than a certain percentage (determined based on when the policy was issued) of the ETPs associated with that policy. This additional step is meant to minimize the number of policies that fail as a result of the 250% test. 

The revisions to the 250% rule will apply to all policies, even those issued prior to 2017. 

Changes to the formula for the Adjusted Cost Base (ACB) of a life insurance policy

The ACB of an insurance policy is important for calculating the taxable policy gain that is caused by certain transactions. Previously, when calculating the ACB of a policy, only the standard premium of the policy was included. Under the new legislation, a policy’s additional premium amount will also be included within the calculations. As a result, the ACB may be higher for a longer period of time for some clients

This higher ACB may result in less of a taxable gain for personally owned policies and will impact the payout of capital dividends for a corporately owned policy.

Conclusion

These legislative changes mark a dramatic change to life insurance taxation. Policies taken out after 2017 will have substantially different assumptions behind them than policies currently issued. These changes will have a significant effect on the taxation of life insurance policies, and any change to life insurance policies should likely take place before January 1, 2017.

If you are considering making any changes to your estate plan or life insurance policy in the future, we recommend that you contact Kelly Santini LLP to discuss how these changes might affect your particular estate plan. 

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Lawrence Silber

Jennifer Cox (articling student)