Insurance can be Taxable

National Post


Life insurance can be divided into two main types: term and permanent. Term insurance has no investment component and pays out a tax-free death benefit if you die during the term of coverage.

By contrast, permanent insurance, generally universal or wholelife, is designed to last throughout your life and often contains an investment component allowing you to build up cash values inside the policy in a tax-sheltered manner. You have the ability to surrender your policy prior to death to access what's known as the cash surrender value (CSV).

The CSV, however, is often far from tax-free, as Karl Kratochwil found out the hard way in Tax Court last month. He purchased a permanent life insurance policy in 1987 that would pay out a death benefit of $300,000 when he died. Because the premiums paid in the early years of his policy exceeded the cost of insurance in those years, a capital reserve was created within the policy that generated investment income, which remained tax-sheltered while inside the policy. Over 15 years, he paid premiums totalling $127,368.

In 2007, Mr. Kratochwil surrendered his policy and received the CSV of $150,365. He reported income on his 2007 tax return of approximately $23,000, which he calculated by simply deducting the total premiums he paid under the policy from the CSV he received as it was his opinion that "the full amount of the premiums paid under the Policy had been refunded to him because the death benefit had not been paid out to him."

What Mr. Kratochwil failed to appreciate was that a significant portion of the premiums was used to pay the cost of the $300,000 coverage, in the same way that premiums are paid to cover the cost of insurance under a basic term-life insurance policy.

The true gain from surrendering his policy, as reported on his T5 slip from Standard Life, was actually $112,090 and as a result, the Canada Revenue Agency reassessed Mr. Kratochwil for $89,090, representing the difference between what he reported and what Standard Life reported. The gain was calculated by Standard Life as the difference between the CSV of $150,365 and the adjusted cost base (ACB) of the policy.

So, what's the ACB of a policy? The ACB is calculated as the premiums paid less the cost of the actual insurance.

Of the $127,368 Mr. Kratochwil paid, $41,771 represented the "net cost of pure insurance" (NCPI), which is the premiums he paid for insurance coverage plus an additional $47,322 of "supplementary premiums" due to the Mr. Kratochwil's insurance risk rating.

As a result, the ACB was $38,275 ($127,368 - $41,771 - $47,322) and the policy gain of $112,090 is simply the difference between the CSV ($150,365) and the ACB.

The judge ruled the gain calculated on the T5 was properly calculated and upheld the CRA's reassessment.