Overview/purpose of accumulating fund (p. 709)
The accumulating fund is intended to represent the savings element in the policy and has historically been the greater of (1) the cash surrender value and (2) the present value of future benefits less the present value of future premiums payable under the policy (effectively the reserve that can be claimed by the insurer in respect of the policy).
For Canadian tax purposes, the accumulating fund determines whether the policy is exempt from the annual accrual rules for life insurance policies, and, if it is not exempt, how much is included in income. There are a number of different policy designs that may provide little or no cash value but can create a significant accumulating fund. For example, in a universal life level cost of insurance (UL LCOI) policy, the mortality charges in the initial years will exceed the annual mortality costs, and such excess is not available to the policyholder as part of the cash surrender value. However, in later years, the excess is available to effectively subsidize the cost of insurance when the policy mortality charges are below the actual mortality cost.
In order for a life insurance policy to qualify as an exempt policy, the inside buildup of value in the policy, as measured by the accumulating fund of the policy, must not exceed certain limits when compared with its benchmark policy. The benchmark policy is known as the "exemption test policy" (ETP).
Shift to one-year pre-test (p. 719)
[T]he rule now requires only a one-year pre-test. This requires the insurance company to project the accumulating fund values to the following policy anniversary, using the most recent information available to the insurance company and without regard to any automatic adjustments made at the policy anniversary date to keep the policy exempt. For current policies, the rule requires that it be reasonable to conclude that the pre-test will be met at all times in the future, including post-endowment. In either case, a policy must meet the pre-test requirements at all times in the past, and once a policy is offside, it can never get back onside.
Example of additional exempt test policy where >8% annual increase in death benefit (p. 720)
Example 1
Assume that a life insurance policy is issued with $1 million of coverage. Further assume a savings element of $3,527, so that the benefit on death at the end of year 4 is $1,003,527. At that stage, year-over-year increases in the benefit on death do not breach the 8 percent threshold (because $1,003,527 is less than the original death benefit increased by 1.08). Now assume that $100,000 is deposited and a yield is earned in year 5 that increases the end-of-year death benefit to $1,114,639. Because this increase is greater than the 8 percent allowed, two ETPs will be created. One has a death benefit of $1,083,808 (108 percent of $1,003,527) and exempt-limit attributes based on the original issue age and the necessary accumulation in the fifth year of the ETP. The second ETP has a death benefit of $30,831 ($1,114,639 − $1,083,808) and exempt-limit attributes based on the attained age at the time the additional ETP was created (the original issue age plus five years in this case) and an accumulating fund of zero. To determine whether the policy will still be exempt, the aggregate savings element is determined for each of these two ETPs, and those amounts are then summed and compared with the policy's actual accumulating fund.
Application of ETP rules at coverage rather than policy level (pp. 720-721)
One significant change to the ETP rules is the application of these rules at the coverage level under the policy rather than at the policy level. This will further restrict the amount of tax-free accumulation within an exempt policy. The coverage-level requirements apply only to policies issued after 2016. This is accomplished by creating the notion of "coverage" under a policy and defining it for the purposes of the ETP rule. [F.N. 58: Regulation 310, paragraph (a) of the definition of "coverage" applies a wide definition for the purposes of the ETP rules in regulation 306, whereas for the purposes of regulations 307 and 308, the definition of "coverage" in regulation 1401(3) applies.]
The effect of applying the ETP rule at the coverage level rather than the policy level can best be illustrated by the following example.
Example 2
Assume that a policy covers the lives of two individuals, one with a death benefit of $700,000 and the other with a $300,000 death benefit Under the current rules, when the 8 percent test is applied at the policy level, the benefit on death can increase in respect of either coverage so long as the benefit on death under the policy as a whole does not increase by more than $80,000. For future policies, any increase in the benefit on death of any coverage under the policy is limited on its own by the 8 percent limit; accordingly, a coverage with an increase in the benefit on death below the 8 percent limit cannot be applied to shield an increase in excess of 8 percent on any other coverage under the policy. In the example, the benefit on death in respect of the $700,000 coverage cannot increase by more than $56,000, and the benefit in respect of the $300,000 coverage cannot increase by more than $24,000. One impact of these changes is that adding coverage to an existing policy will create no more deposit room than buying a new stand-alone policy.
Redating of exempt test policy where >250% increase in accumulating fund over 3 years (p. 721)
In addition to the so-called 8 percent test, another rule currently applies to limit 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 accumulating fund of the actual policy on the 10th and every subsequent policy anniversary with the accumulating fund of the actual policy on the 3d preceding policy anniversary. If the ratio of the accumulating fund in the current year to the accumulating fund on the 3d preceding anniversary exceeds 250 percent (the so-called 250 percent test), the ETPs of the policy are deemed to have been reissued on the later of the 3d preceding policy anniversary and the date on which the relevant ETP was issued. This "re-dating" of the ETP will reduce the amount that can be accumulated in the actual policy, because the policy will have an accumulating fund based on a policy that has been in force for only 3 years. In situations where the policy has been funded at a minimum level, this could potentially make it difficult for the policyholder to make sufficient deposits to result in the policy being "paid-up" [f.n. 61: A "paid-up" policy is one that has sufficient cash values 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 pay any further premiums or make additional deposits to the policy to keep it in force.] at a later date. Traditionally, this re-dating of ETPs has been avoided by ensuring that the policyholder withdraws funds from the policy prior to the application of the test. [f.n. 62: The amount withdrawn would have to ensure that the policy no longer fails the 250 percent test.]
Effect of changes to the calculation of the accumulating fund for future policies (pp. 723-4)
There are significant changes to the calculation of the accumulating fund for the ETP for future policies. Instead of using the pricing basis of the actual policy, the insurance companies must use fixed assumptions for interest (3.5 percent) and mortality (using the Canadian Institute of Actuaries' [CIA] 1986-1992 mortality tables). As well, an 8-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). [f.n.70… “interpolation time” and “endowment date…regulation 310] The exemption test rules have also been clarified to ensure that the test continues to apply beyond age 90. [f.n. 71… “pay period”…regulation 310]
Similarly, the accumulating fund of the actual policy will no longer be based on product-pricing assumptions but will use fixed interest and mortality assumptions on the same basis as the accumulating fund of the ETP (3.5 percent interest and the CIA 1986-1992 mortality tables). In addition, the cash surrender value of the policy will be determined before surrender charges.73 The reserve basis of the policy will change from the 1.5 year preliminary term methodology to a "net premium reserve" (NPR) basis. [f.n. 74…“net premium reserve”…1401(3)]
By comparison with the current rules, the accumulating fund of the ETP will be higher in the first 10 to 12 years of the policy but trending lower thereafter until age 90. On the other hand, the accumulating fund of the actual policy will generally be higher at all policy durations by comparison with the current rules. The net effect (in relation to current policies) will generally be similar to higher accumulation room in the first 10 years and then a reduction in the maximum amount that may be accumulated. However, the impact of these changes will be significantly greater for UL LCOI policies, since surrender charges will now be ignored and the embedded reserve will be included in determining the accumulating fund of the actual policy.
Impact on universal life level cost of insurance (p. 724)
[T]he impact will be more pronounced for UL LCOI "life-pay" policies at younger ages and have less of an impact on policies with higher premiums paid over a shorter period of time. It should also be noted that only a small percentage of policyholders pay premiums to achieve the maximum permitted accumulation room over the lifetime of the policy. As a result, in the majority of situations, policyholders will not experience any practical impact from these changes to the exemption test.
Impact of changes in Part XII.3 (IIT) tax on UL LCOI policies (pp. 737-8)
- For policies issued after 2016, the embedded reserve for UL LCOI policies will be included in determining the IIT base, if it is not already included.
- The policy reserve will continue to use the 1.5-year preliminary term method based on cash surrender value or pricing assumptions, including lapses for lapse-supported products.
It is expected that the change in IIT on UL LCOI [universal life level cost of insurance] policies, if flowed through to policyholders, will have a significant impact on COI [cost of insurance] rates at younger ages (in the range of 6 to 9 percent), gradually decreasing at older ages (for example, 3 percent or less for insured individuals over the age of 60). There will also be an impact on level limited-pay universal life policies (whether on a level cost or yearly renewable term cost).
Impact of death benefit on adjusted cost basis of a multi-life policy (pp. 730-1)
New paragraph 148(2)(e)…applies to a situation where an insurance death benefit is paid that results in a termination of coverage but not termination of the policy—that is, there are other coverages under the policy that remain in effect. If the fund value benefit [f.n. 109… defined in regulation 1401(3)] that is paid out exceeds the maximum amount permitted in respect of the terminated coverage,[f.n. 110: … regulation 306(4)(a)(iii)] a policyholder with an entitlement to the excess portion is deemed to have disposed of a "part of an interest" for proceeds equal to that excess portion. …
Example 4
Corporation A purchases a multi-life policy after 2016 with the following coverages:
- life-insured 1—$1 million;
- life-insured 2—$100,000.
Assume that on the fifth anniversary of the policy, the total cash value is $120,000 and the ACB of the policy is $80,000. Further assume that if the insurance coverage had been issued separately, the maximum fund value at the fifth policy anniversary for the coverage on life-insured 1 would have been $120,000, and for life-insured 2 it would have been $20,000.
If we assume that life-insured 2 dies at this point in time, corporation A will receive a death benefit of $220,000, consisting of the $100,000 coverage on this life-insured and the $120,000 fund value.
As discussed below [not included], paragraph 148(2)(e) will deem $100,000 of the fund value death benefit to be proceeds of the disposition. In determining the taxable amount of the proceeds, subsection 148(4) will require an allocation of the ACB of the policy as follows:
$80,000 (full ACB) × 100,000/120,000 = $66,667.
This will result in a taxable gain of $33,333 ($100,000 proceeds less $66,667 ACB).
Deeming of partial surrender of policyholder’s interest so as to reduce policy loan to be loan repayment followed by partial surrender (pp. 732-3)
This will result in a taxable gain of $33,333 ($100,000 proceeds less $66,667 ACB).
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. Subsection 148(4.01) will adjust the ACB of the interest in the policy to avoid the potential for double taxation of the same gain in the future.
Example 5
Policy Issued Before 2017
Assume that Mr. B has a policy with an ACB of $40,000 and a cash surrender value of $120,000. Mr. B withdraws $30,000 from the policy. This withdrawal constitutes proceeds from the disposition of an interest in the policy. Under subsection 148(4), the pro rata ACB associated with this disposition is $10,000 ($40,000 × $30,000/$120,000). This results in a taxable gain of $20,000 (proceeds of $30,000 − ACB of $10,000). The ACB of the policy is now $30,000, being reduced by the proceeds of disposition and increased by the taxable gain reported on that disposition, and the cash surrender value of the policy has been reduced to $90,000.
Now assume that instead of taking a partial withdrawal of $30,000 from the policy, Mr. B first takes a policy loan for $30,000. While a policy loan is treated as a disposition of an interest in the policy, subsection 148(4) does not apply to prorate the ACB of the policy. As a consequence, since the ACB of the policy exceeds the amount of the policy loan, there is no reportable gain on the taking of the policy loan. However, the ACB of the policy is reduced from $40,000 to $10,000.
Assume that Mr. B subsequently makes a withdrawal from the policy to repay the policy loan. This would initially result in proceeds of disposition of $30,000. However, the definition of "proceeds of the disposition" reduces these proceeds by the amount used to repay the policy loan ($30,000), [f.n. 112: See subparagraph (i) of element C of paragraph (a) of the definition of "proceeds of the disposition" in subsection 148(9).] resulting in nil proceeds of disposition. The end result is that Mr. B has been able to withdraw $30,000 from the policy without any amount being included in income (in effect, avoiding the ACB proration rules in subsection 148(4)). The ACB of the policy at this point remains at $10,000, and the cash surrender value is $90,000. Consequently, there remains $80,000 of accrued gain that would be taxable upon a subsequent disposition of the entire policy.
Policy Issued After 2016
The definition of "proceeds of the disposition" has been amended so that the proceeds arising from a partial withdrawal will not be reduced by the amount of any policy loan outstanding where the policy loan has previously been taken in cash (rather than used to pay premiums). As a consequence, the partial withdrawal by Mr. B to repay the policy loan will result in proceeds of disposition of $30,000. Subsection 148(4) will then apply, and the ACB of the interest in the policy will need to be prorated to determine whether there is a policy gain. In determining the ACB of the policy, subsection 148(4.01) deems the policy loan of $30,000 to have been repaid immediately before the partial surrender. As a consequence, the ACB of the policy will increase from $10,000 to $40,000 and the prorated ACB will be $10,000 ($40,000 × $30,000/$120,000), resulting in a $20,000 policy gain. As well, the ACB of the policy will be adjusted to equal $30,000. Note that this is the same result as under the initial fact pattern, where there was no policy loan taken in advance of the policy surrender.
Effect of net cost of pure insurance on policy ACB (pp. 733-4)
The NCPI of a policy reduces the ACB of policies last acquired after December 1, 1982 [f.n. 114: The total of all annual NCPI charges reduces the ACB of the policyholder's interest in a policy by virtue of element L of the definition of "adjusted cost basis" in subsection 148(9). The rules for calculating the NCPI of an interest in a life insurance policy are set out in regulation 308.]
Generally, the NCPI determined for an insurance policy will increase every year as the life-insured grows older. For "level-pay" insurance policies, [f.n. 116: For example, guaranteed whole life, participating life, and UL LCOI [universal life level cost of insurance] policies.] this creates a pattern in which the ACB of the policy increases in the early years (as a result of premium or deposit payments and lower NCPI deductions) but at later durations the ACB is reduced to nil (as a result of an NCPI charge that exceeds the premium or deposits paid into the policy).
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