24 April 2002 External T.I. 2002-0128665 - GAIN ON SURRENDER OF LIFE INSURANCE

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues:

Whether information provided by the insurer and taxpayer has been properly reflected in the calculation of the proceeds of disposition and adjusted cost basis of the policy surrendered by the taxpayer.

Position: Yes

Reasons:

Review of relevant provisions. Presentation of the components by the Insurer has been confusing or misleading but the ultimate calculations appear correct.

XXXXXXXXXX 2002-012866

April 24, 2002

Dear XXXXXXXXXX:

Subject: Gain on Surrender of Life Insurance Policy

This is in reply to your inquiry which was forwarded to us by the Client Services Division of the XXXXXXXXXX Tax Services office on March 14, 2002. Your question related to the information received from your insurer on the surrender of a life insurance policy which indicated that you must report a gain for tax purposes of $19,976.28.

Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an Advance Income Tax Ruling request. Where the particular transactions are completed, the inquiry should be addressed to the relevant Tax Services Office, as you have done. Due to the complex nature of your situation, the Tax Services Office has requested our assistance in responding to your inquiry and we are therefore responding directly to you. A copy of the letter will also be provided to the XXXXXXXXXX Tax Services Office.

We have reviewed the information you provided to the tax services office which includes your correspondence with the insurer. We note that we are only able to comment on whether the tax consequences reported by the insurer are consistent with the application of the provisions of the Income Tax Act (the "Act") that define the proceeds of disposition from the surrender of a policy and the adjusted cost base of a policy. We are not in a position to verify the correctness of any of the figures provided by the insurer such as the amount of the Net Cost of Pure Insurance ("NCPI") or the amount of the Cash Surrender Value ("CSV"). Based on our review of the information provided in writing and some additional information provided by telephone, it is our view that the calculation of the taxable gain on your policy is consistent with this information.

General Taxation of Exempt Life Insurance Policies

Given that the insurer did not provide you with annual income reporting slips, during the years you held the policy, for the purpose of reporting income earned within the insurance policy under section 12.2 of the Act, we have assumed that the policy is on that is referred to as an "exempt policy" for tax purposes. The term "exempt policy" does not mean that the investment income earned in the policy will never be subject to taxation, but rather that the investment income will not be subject to the annual income accrual rules in section 12.2 of the Act. The investment income earned under an exempt policy will generally be fully taxable at the time the policy is disposed of for the purposes of the Act, on surrender or maturity. It may also be partially taxed prior to surrender or maturity in the event of a partial disposition of an interest in the policy. We understand that no income has previously been reported for tax purposes in respect of the policy.

When a policy is surrendered, subsection 148(1) of the Act will apply to require the policyholder to report a gain for tax purposes to the extent that the proceeds of disposition of the policy exceeds the adjusted cost base of the policy at the time of surrender. In the case of an exempt policy, the result of this computation should be that the full amount of the investment income earned under the policy is subject to taxation at the time the policy is surrendered.

Computation of the Proceeds of Disposition of a Policy

The proceeds of disposition on the surrender or maturity of an insurance policy is provided for under paragraph (a) of the definition of "proceeds of disposition" in subsection 148(9) of the Act. The formula in this paragraph of the Act provides that the proceeds of disposition are to be determined by reducing the CSV of the interest in the policy at the time of the surrender, by the amount payable at the time of surrender in respect of a policy loan in respect of a policy. An "amount payable" in respect of a policy loan is defined in subsection 148(9) of the Act to have the meaning assigned by subsection 138(12) of the Act. The definition of "amount payable" in subsection 138(12) of the Act provides that it includes the amount of the policy loan and any interest accrued thereon that is outstanding at that time. It is therefore appropriate in this case for the proceeds of disposition to be the CSV of the policy less the total of the outstanding policy loans and unpaid interest on the policy loans.

Adjusted Cost Base of an Insurance Policy

The "adjusted cost base" of a policyholder's interest in an insurance policy is determined by a formula under subsection 148(9) of the Act. In very general terms, the adjusted cost base of a policy to the original policyholder will be the amount by which the cash premiums paid by the policyholder, and any income in respect of the policy that has previously been reported for tax purposes, exceeds the NCPI under the policy. In looking at the detail in the formula in respect of a policy issued in 1986, as in your case, some components of the formula may be ignored as they deal with policies that were held by the policyholder on March 31, 1978.

A of the formula will apply when the taxpayer is not the original taxpayer under the policy but that is not the case here.

B of the formula adds in amounts in respect of premiums paid under the policy, except for premiums described in three specific provisions of the Act. These premiums that are not to be included in B are premiums paid out of income from the policy that have not yet been subject to taxation. Subsection 148(2) deems policy dividends to result in a disposition. Clause 148(2)(a)(ii)(B) provides that in computing the gain from the disposition, the proceeds of disposition are reduced by the amount of the dividends immediately applied to pay a premium under the policy or a policy loan under the policy, as provided for under the terms or conditions of the policy. Consequently, where the full amount of policy dividends are applied to pay a premium under the policy as provided for under the terms or conditions of the policy, the proceeds of disposition would be nil and no amount would be included in computing income of the taxpayer in respect of the policy dividends. Because there are no income inclusions at the time the policyholder becomes entitled to the dividends, B excludes the premiums paid from these policy dividends from being added to the adjusted cost base of the policy.

The definition of "disposition" in subsection 148(9) provides that a policy loan issued after March 1978 is a disposition for the purposes of subsection 148(1) of the Act. Subparagraph (i) of paragraph (b) of the definition of "proceeds of disposition" provides that in computing of the proceeds of disposition with respect to a policy loan made after March 1978, the amount of the loan is reduced by the amount of the loan that is applied immediately thereafter to pay a premium under the policy as provided for under the terms and conditions of the policy. Where all of the policy loan amount is used to fund premiums under the policy as provided for under the terms and conditions of the policy, the proceeds of disposition would be nil and no amount would be included in computing income of the taxpayer in respect of the policy dividends. Because there is no income inclusion at the time the policy loan is made, B of the adjusted cost base formula, excludes the premiums paid from policy loans.

The third exclusion from the inclusion of a premium under B is a premium paid from surrender proceeds immediately after the time of surrender, as provided for under the terms and conditions of the policy, but does not appear to apply in this case.

Therefore, the only premiums which would be included under B of the computation of the adjusted cost base is the $58,905 of cash premiums paid under the policy.

C of the formula includes in the adjusted cost base, amounts in respect of dispositions of an interest in the policy that were required to be included in income in prior years. This would include gains from policy dividends or policy loans not used to pay premiums under the policy as provided for under the terms and conditions of the contract. This component does not seem to apply in this case.

E of the formula increases the adjusted cost base in respect of post-March 1978 policy loans repaid. Since it does not appear that the taxpayer repaid any of the policy loans prior to the surrender of the policy, there is nothing to add under this component of the formula.

D, F, G and G.1 of the formula are not relevant in this case as they deal with types of policies that are not being considered in this case.

H of the formula reduces the adjusted cost base by the amount of proceeds of disposition received or receivable before the particular time. Based on the information provided, the only dispositions in respect of the policy that were realized prior to surrender of the policy were the policy dividends and policy loans. As discussed above, the proceeds of disposition with respect to both the dividends and the loans was nil and therefore no amount is subtracted under H.

I, J and K of the formula are not relevant in this case as they deal with types of policies that are not being considered in this case.

L of the formula reduces the adjusted cost base of a post-December 1, 1982 policy that is not an annuity by the NCPI in respect of the policy. This is the amount that the policyholder has effectively paid to be covered by the insurance during the time that he or she has held the policy. By deducting this amount in computing the adjusted cost base, the balance of the adjusted cost base, if any, represents the adjusted cost base of the investment component of the policy. The insurer indicates that the total NCPI under the policy is $61,456. If you are concerned as to whether it is appropriate to reduce the adjusted cost base of an insurance policy by the amount of the NCPI, this is a policy matter that you may wish to discuss with the Department of Finance which has responsibility for policy matters.

You questioned whether it is reasonable that the NCPI of the policy for the first 9 years was less than the premiums paid under the policy for the same period while in the later years of the policy the NCPI was higher than the premiums paid. We are not in a position to assess the correctness of the NCPI amount provided by the insurer, as only the insurer has the necessary information to compute this amount. However, from a conceptual perspective the relationship between NCPI and premiums that you describe would be considered normal under a policy that requires a the same annual premium over the term of the policy. As a person ages, the risk of the insurer having to make a payout under the policy increases and therefore the NCPI increases. Since the annual premiums are expected to remain the same throughout the term of the policy, but the cost of insurance is increasing as the life insured ages, it is not unusual that in the early years of the policy the annual premium will exceed the annual NCPI and in later years the annual NCPI will exceed the annual premium. The income earned on the excess annual premiums in the early years is anticipated to off-set the short-fall of premiums below NCPI in later years of the policy.

Should you have any concerns with respect to amounts reported to you by the insurer, such as the amount of the NCPI, the CSV, the policy loans, policy loan interest or policy dividends, these should be addressed to the insurer. If you would like some assistance in dealing with the insurer, you may wish to contact the Consumer Assistance Centre of the Canadian Life and Health Insurance Association. They can be reached at 1-800-268-8099 or may be contacted through their website at www.clhia.ca.

Based on the foregoing and the information provided to us, the adjusted cost base of the policy in this case is the premiums of $58,905 less the NCPI of $61,456. The result, which is negative, it is deemed to be nil by section 257 of the Act.

Policy Gain

As discussed earlier, the policy gain on the surrender of a policy is determined under subsection 148(1) of the Act, as the amount by which the proceeds of disposition, exceed the adjusted cost base of the policyholder's interest in the policy. In this case, the proceeds of disposition as determined above are $19,976 and the adjusted cost base is nil. Therefore, a policy gain in the year the policy was surrendered of $19,976, would be consistent with the application of the provisions of the Act to the information provided. We would note that an insurance policy is not a capital property and therefore the gain is fully taxable and not subject to the reduced capital gains inclusion rate.

We hope that this information will be of assistance to you.

Yours truly,

F. Lee Workman
Section Manager
for Division Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch