1 May 2007 External T.I. 2007-0230321E5 - Disposition - Interest in a Life Insurance Policy

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.

Principal Issues: General comments on the tax consequences of the disposition of a life insurance policy with a "return of premium" benefit.

Position: Generally results in a taxable gain.

Reasons: The legislation

XXXXXXXXXX  						2007-023032

May 1 2007

Dear XXXXXXXXXX:

Re: Disposition of an Interest in a Life Insurance Policy

This is in reply to your letter of March 26, 2007, addressed to the Summerside Tax Centre, in which you requested our comments on the tax implications relating to the disposition by your clients, XXXXXXXXXX, of insurance policies issued to them by XXXXXXXXXX. It is our understanding that both insurance policies matured on XXXXXXXXXX, 2006, and XXXXXXXXXX issued T5 reporting slips to your clients showing amounts that your clients must report as "Interest Income from Canadian Sources" on their 2006 tax returns, as a consequence of the disposition of the insurance policies. It is your view that there should be no taxes payable by your clients in respect of the disposition of the insurance policies as the amounts your client's received on the disposition of their policies were the "return of premiums" that had been paid under the policies.

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. However, as requested, we are prepared to provide you with our view on the general tax consequences resulting from the disposition of a term life insurance policy with a "return of premium" benefit.

General Comments

A "disposition" of an interest in a life insurance policy is defined in subsection 148(9) of the Income Tax Act (the "Act") to include "a surrender thereof" or "the dissolution of that interest by virtue of the maturity of the policy." When a policy is surrendered or matures, 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 exceed the "adjusted cost basis" ("ACB") of the policy immediately before the disposition. Any gain resulting from the disposition is required to be included in the policyholder's income by virtue of paragraph 56(1)(j) of the Act.

Proceeds of Disposition

The "proceeds of the disposition" of an interest in a life insurance policy is defined in subsection 148(9) of the Act as the amount of the proceeds that the policyholder is entitled to receive on the disposition. Where the terms of a policy provide for a benefit to be paid out on the surrender or maturity of the policy, such benefit would be included in the computation of the proceeds received by the policyholder. The type of policy in this case provides for a payout of a "return of premium" benefit as determined by reference to the total premiums paid in respect of the particular policy.

ACB of a Life Insurance Policy

The ACB of a policyholder's interest in a life insurance policy is determined by a formula under subsection 148(9) of the Act. In very general terms, the ACB 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 "net cost of pure insurance" (NCPI) under the policy.

The NCPI represents the cost the policyholder has paid to be covered by insurance during the time that he or she has held the policy and as such reduces the amount that can be returned to the policyholder on a tax free basis when the policy is surrendered. Section 308 of the Income Tax Regulations to the Act sets out the rules for calculating the NCPI of a taxpayer's interest in a life insurance policy.

Gain on Disposition

As indicated above, the application of subsection 148(1) of the Act results in a gain where the proceeds of disposition of the policyholder's interest in the policy exceed the ACB to the policyholder of that interest. The gain computed under subsection 148(1), must be included in computing the income of the policyholder in the year the disposition takes place, pursuant to paragraph 56(1)(j) of the Act.

The insurer with whom the policy was held prior to its maturity or surrender should report the amount of the gain on the policy in "Box 14- Other Income from Canadian Sources" on a T5 information slip it issued to the policyholder. The amount should not be reported as "Box 13- Interest Income from Canadian Sources". The insurer should also be able to provide you with information on how it calculated the "proceeds of disposition", "adjusted cost basis" and the gain on the disposition.

You also requested that we provide you with a reference to publications that outline your rights should you disagree with an assessing position of the CRA. On the CRA website at www.cra-arc.gc.ca there are two publications that should be of assistance to you in this regard: pamphlet P 148 which is entitled "Your Appeal Rights Under the Income Tax Act", and guide RC 4213 which is entitled "Your Rights: In Dealing With the Canada Customs and Revenue Agency".

We hope that our comments will be of assistance to you.

Yours truly,

F. Lee Workman
Section Manager
Charitable and Financial Institution Sectors
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch