For years, life insurance has been an integral part of business owners’ tax and financial plans. Beyond the basic benefit of insuring you leave money behind to your heirs, the tax treatment of certain policies, called exempt policies, have made them advantageous over other types of investments. Since 1982, the rules surrounding the taxation of exempt tax policies had remained essentially unchanged. On Jan. 1, 2017 a new reform comes into force that will dramatically alter the landscape.
The Tax Treatment of Life Insurance Policies
Most businesses are legally structured as corporations. If a corporation is the beneficiary of a life insurance policy, such as on its owner’s life, the insurance benefit that the company receives upon the death of the shareholder is almost entirely credited to the company’s capital dividend account. Capital dividends can then be paid to the deceased shareholder’s estate. Capital dividends are tax-free. This makes it very interesting for corporations to take out life insurance on their shareholders, especially late in life.
Using this beneficial treatment has long been a part of a small business owner’s planning. It is especially appealing if there are other shareholders that will continue the business and the estate needs to be bought out.
Under the earlier rules, exempt insurance policies have allowed an insured person to pay the premium in an accelerated manner and to pay an amount greater than the premium into the policy. As a result, the extra cash in the policy could be invested to generate a return. This return, under under the previous rules, is tax-free. Taxation on this extra money occurs only upon the person’s death when the policy is wound up, thus giving the insured a lucrative tax deferral, in much the same way as a registered retirement savings plan (but without the deduction for contributions).
The 2017 Changes and Their Implications
For years, the Canada Revenue Agency has acknowledged that most of the tax planning surrounding life insurance policies is legal, but the CRA was uncomfortable with some of the advantages it created. The new rules aim at curbing the advantages described above and bringing life insurance policies back closer to their original purpose.
Essentially, the new rules will seek to accomplish two goals: reducing the investment portion of exempt policies by lowering the amount that can be paid into the policy, and modifying the attribution of death benefits to the capital dividend account to take into consideration more realistic life expectations. Policies that were entered into prior to the end of 2016 will be grandfathered and will continue to use the old rules, as long as they remain unchanged.
These are highly technical planning techniques, and the changes to the law are also highly technical. Consult with your tax advisor before making any changes to your life insurance policies.