Ensure they understand how products are taxed
Advisors who are life-licensed no doubt have an intimate knowledge of the complex rules surrounding the taxation of life insurance policies, both before and after death. That being said, how many of us take the opportunity to explain these rules in easy-to-understand language to our clients?
A tax case (Brousseau v The Queen, 2006 TCC 646), which was just recently released in its official English translation, sheds some light on how confused the general population must be when it comes to even the basics of insurance policy taxation.
On April 24, 1984, Bernard Brousseau purchased a $135,000 life insurance policy from Standard Life with a 20-year term. The policy had a clause guaranteeing a refund of premiums, without interest, upon the maturity of the policy.
Consequently, 20 years later, on April 24, 2004, Mr. Brousseau took advantage of this feature and Standard Life paid him $14,983, which was approximately equal to 20 years’ worth of the premiums that he had paid. (In fact, Mr. Brousseau had paid $16,121 of premiums, which reflects the fact that he paid his premiums on a monthly basis as opposed to annual.)
Under the Income Tax Act, a payment under a premium refund guarantee is considered to be a “disposition” of the policy. As a result, the Act specifies that the amount to be included in a policyholder’s income from the disposition of a life insurance policy is determined pursuant to the provisions of section 148, which provides that income inclusion = Proceeds of Disposition - Adjusted Cost Basis (ACB) of the policy.
Both the calculation of “proceeds of disposition” and the ACB of a life insurance policy are found in their respective definitions in subsection 148(9) of the Act.
The proceeds are typically equal to the amount that the policyholder is entitled to receive from the insurer or, in this case, the “refund of premiums.” Similarly, the ACB of a life insurance policy is calculated by deducting the “net cost of pure insurance” (NCPI) under a policy from the amount of the premiums that were paid to acquire the insurance policy.
Following these rules, Standard Life calculated the income inclusion to Mr. Brousseau as $11,886 and reported it as such on a T5 Slip issued to him for 2004. The income inclusion was calculated as follows:
Proceeds — Refund of Premiums:
$14,983.00
Less: ACB of policy — see below:
(3,097.00)
Taxable amount
$11,886.00
Adjusted cost basis (ACB) of the policy:
Total premiums paid:
$16,120.91
Less: Net Cost of Pure Insurance:
(13,023.91)
Adjusted cost basis
$3,097.00
Mr. Brousseau objected and felt that the net cost of pure insurance should not be taken into account in computing the adjusted cost basis of the policy “because, in his opinion, his policy does not contain the factors that section 308 of the Regulations requires in order for such a calculation to be done.”
Section 308 of the Income Tax Regulations states that: “the NCPI for a year in respect of a taxpayer’s interest in a life insurance policy is the product obtained when the probability, computed on the basis of the rates of mortality … that a person who has the same relevant characteristics as the person whose life is insured will die in the year is multiplied by the amount by which (a) the benefit on death in respect of the taxpayer’s interest at the end of the year exceeds (b) the accumulating fund … in respect of the taxpayer’s interest in the policy at the end of the year or the cash surrender value of such interest at the end of the year.”
Mr. Brousseau felt that since his policy did not provide for an accumulating fund in relation to his interest in the policy, “one must not deduct the next cost of pure insurance from the total premiums paid” in arriving at his ACB.
Naturally, the judge disagreed and found “nothing in the insurance policy in question that would suggest that the net cost of life insurance should not be computed upon the refund of the premiums on maturity.” She ordered the full policy gain taxable to Mr. Brousseau as calculated by Standard Life.
Could this lawsuit have been avoided? Absolutely — through better investor education. That’s why it’s imperative we continue to educate our clients about not only the product features (e.g., refund of premiums) associated with a particular policy or investment, but also the tax laws surrounding the proper use of these products.