Policy loan and policy loan interest taxation – it’s complicated!
Most people don’t know that life insurance has special, favourable tax treatment. Life insurance death benefits are generally tax-free, and cash values within life insurance policies can grow on a tax-sheltered basis. But to benefit from this favourable treatment there are lots of complicated tax rules. For policyholders, sometimes T5 statements arrive in their mailboxes, and they don’t understand why.
Some people might write to the CRA to clarify why they’re getting a T5. That’s exactly what happened with a pre-2017 policy (called G2 policies). The CRA’s response is captured in technical interpretation #2016-0658641E5. In it, the CRA did its best to explain the taxation of life insurance and, in particular, policy loans and policy loan interest when it’s capitalized.
But I’m still not sure the policyholder now understands why he got a T5 any better than he did before! Maybe this summary could have helped the CRA explain things to the confused policyholder:
In general, tax may only arise on an exempt policy where there is a disposition of the policy.
In general, the proceeds of the disposition minus the adjusted cost basis of the policy, if positive, is reported on a T5 as a taxable policy gain.
Taxable policy gains are not capital gains. Taxable policy gains are fully taxable as ordinary income just as interest income is.
In general, the adjusted cost basis is adjusted when a disposition occurs. The proceeds of the disposition reduce the adjusted cost basis and any policy gain is added to the adjusted cost basis.
A policy loan is a disposition of the policy and the loan amount is the proceeds of the disposition.
Policy loans charge interest just as other types of loans do.
Policy loan interest may be deductible for tax purposes, if the borrowed money (the policy loan amount) is used to gain or produce income from a business or property.
To deduct policy loan interest, the policyholder needs to verify the amount with the insurer using a CRA form T2210.
Policy loan interest is capitalized when the loan interest is not paid with external dollars but is paid by taking a policy loan to pay the interest. This may happen automatically as part of the insurance policy’s standard administrative practice. If policy loan interest is capitalized, it could result in a disposition and be subject to tax.
If capitalized policy loan interest is deductible for tax purposes, the capitalized interest is considered a policy loan which could be taxable.
If capitalized policy loan interest is not deductible, the capitalized interest is considered a policy loan and the payment of a premium at the same time. This means that the adjusted cost basis remains flat resulting in no tax consequences.
Sometimes a policy loan is taken automatically under the contract to keep a policy in force (policy continuation loans). For policy continuation loans taken to pay an eligible premium, the proceeds of the disposition are considered to be zero. Here are types of items that are not considered to be eligible premiums: premiums for accidental death benefits; disability benefits; substandard ratings; the cost of converting a term policy to another type of policy; settlement options, and guaranteed insurability benefits.
Generally speaking, loan interest that relates to policy continuation loans is not tax deductible.
Not surprisingly, policyholders are often confused by these rules. Every few years, a question like this one comes to the CRA. (see AAMOT Policy loan rules are finicky)
To make matters that much more complicated, for policies issued after 2016 (called G3 policies) there are slight adjustments to the taxation of policy loans. I’m sure the CRA will get a question about the G3 policy taxation rules eventually.
Here’s what's new for G3 policies.
Generally, the tax treatment of policy loans depends largely on whether or not the policy loan is a cash loan (paid to the policyholder) or a policy continuation loan. The G3 rules treat all premium payments as eligible. Most of the rules applicable to G2 policies still apply, with these exceptions:
Since all premium payments are eligible, policy continuation loans will usually have zero proceeds of disposition.
For G2 policies, a policyholder can typically repay a policy loan with internal policy values without triggering a taxable gain. For G3 policies, this is only the case if the policy loan balance arose from policy continuation loans. Surrender proceeds are not reduced when a surrender is used to repay a cash policy loan.
For G2 policies, when a policyholder misses an eligible premium payment and a policy continuation loan results, there is no proceeds of disposition. However, when that policy continuation loan is repaid with cash, there is also no adjusted cost basis increase. This is a technical glitch in the rules; if the eligible premium had been paid on time (without the need for a policy continuation loan), the premium payment would increase the policy’s adjusted cost basis. This glitch has been fixed for G3 policies.
Some changes have been made to the treatment of capitalized interest, particularly if that interest is later deducted. The G3 rules are more complex in this area depending on whether the interest is being capitalized on a cash policy loan or a policy continuation loan.