Income Tax Act Commentaries

Commentary: Sections 211-211.1 – Tax on Investment Income of Life Insurers (Part XII.3)

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Tax Policy Developments

1977 Budget:

The present system of taxation of life insurance companies was introduced in 1969 when, subject to minor exceptions, the industry became liable for a profits tax for the first time. It has taken several years to assess the new tax system for life insurance companies. It is now apparent that major changes are in order to ensure that all insurance companies bear their fair share of tax in the future.

A comprehensive description of the changes introduced in the budget affecting life insurance is included in the Supplementary Information. However, some of these changes affect individual policyholders and are summarized below. 1

15 Percent Tax on Investment Income Destined for Policyholders

Under Part XII of the Income Tax Act, insurance companies are obliged to pay a 15 per cent tax on any investment income which will eventually be distributed to policyholders. This tax was imposed so that it would not be more attractive to save money through the ownership of a life insurance policy or certain annuities than through other forms of savings. However, when the government introduced the $1,000 exemption for interest and dividend income, the balance between competing forms of savings may have been upset. Therefore, the Part XII tax will be repealed and the investment income on life insurance policies and annuities will be allowed to accumulate tax-free for the benefit of the policyholder. However, the policyholder or annuitant will eventually be subject to tax on this income as described in the next paragraph.

Taxation of Policyholders

Under the present tax regime, no portion of life insurance proceeds is taxable when received as a result of the death of an individual. Alternatively, where a policyholder cashes in a policy he is now taxable on the excess of its cash surrender value over his premiums (net of policy dividends) paid by him on the policy. This represents the untaxed savings element of the policy. Life insurance proceeds on death will be taxed in the same manner. That is, tax will be imposed on the policyholder on the assumption that he had surrendered his policy just prior to death. A value will be established for each policy as of its next anniversary date to ensure that only the savings element of the policy accumulated after that anniversary date is taxed on the death of a policyholder. Many policies will not be subject to tax at all. Of those that are, only a small proportion of the proceeds will be taxable.

Policy Loans

When an insurer advances funds to a policyholder against the cash surrender value of that policy, the advances are actually prepayments of the policyholder’s entitlement under his policy contract. Until now, the industry and policyholders alike have treated these prepayments as loans. Effective in 1978, it will be made clear that for tax purposes these advances are not loans but merely prepayments of the policyholder’s entitlement and therefore that the charge paid to the insurer by the policyholder in respect of the advance is an additional premium.

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