Adjusted Cost Basis

The adjusted cost basis (“ACB”) of a life insurance policy is important when a policyholder wants to dispose of all or a portion of his or her policy, or when a corporation receives life insurance proceeds and needs to calculate the resulting credit to its capital dividend account.

The definition of ACB in the Income Tax Act (“ITA”) is complex, containing eight factors that increase the ACB and five factors that decrease the ACB. Each component is calculated separately on an accumulating basis, and the ACB is calculated by adding together the positive components and deducting the negative components. The ACB of a policy can be negative; however, where that is the case, a value of “nil” or zero is used in any policyholder tax calculation.

The two main items that affect the ACB calculation are the:

• “premiums” paid, which increases ACB; and,
• “netcostofpureinsurance”,whichdecreasesACB.

The term “net cost of pure insurance” sounds technical in nature, and one might expect that the ITA would contain a detailed definition of the term (indeed it does, but that is beyond the scope of this article). In general, the term “net cost of pure insurance” represents an annual mortality cost that increases each year as the life insured gets older.

The meaning of “premium”, on the other hand, may seem fairly clear at first glance; however, that is a false perception. For example, the ITA definition of premium excludes any amount paid with respect to an accidental death benefit, a disability benefit, or an additional amount for substandard risk under the policy in question.

This definition of premium was the subject of a recent case before the Tax Court of Canada. The facts of the case are as follows:

•  A policy was issued to Karl Kratochwil on January 14, 1987.
•  In August 1993, the policy obligations were assumed by Standard Life.
•  The policy was surrendered on August 2, 2007, for its cash surrender value of $150,365.75.
•  The premium for the basic insurance coverage, without any additional risk element, was $421.75 per month, or $75,915 over the life of the policy.
•  The premium associated with insurance coverage for risks beyond the basic insurance coverage was $262.90 per month, or $47,322 over the life of the policy.
•  In addition, there was an additional risk charge of $172.15 per month for 24 months, or $4,132 in total.

In filing his personal tax return in 2007, Karl claimed $22,997 as the policy gain with respect to the surrender of the policy. Karl arrived at the gain by subtracting the sum of all premiums paid under his policy from the cash surrender amount received. Karl filed his tax return prior to having received a T5 slip from Standard Life. That T5, however, showed a policy gain of $112,094 with respect to the disposition of the life insurance policy.

The Canada Revenue Agency (CRA) reassessed Karl, adding $89,094 to his 2007 income.

Karl objected to the CRA’s reassessment and appealed to the Tax Court of Canada. The Tax Court judge quickly dispatched the case, noting in the judgment; “I have reviewed the Minister’s calculations … and have determined that they are accurate.”

The court case does not specifically address the reason behind Karl’s appeal of the CRA’s assessment; however, Karl obviously disagreed with the assessment and was likely perplexed as to why the full amount of premium he had paid from after-tax dollars was not returned to him tax-free.

The communication gap in this case lies in two facts. First, the ITA defines the term premium, and a plain English meaning of the word does not suffice. Secondly, the cost of insurance (or NCPI) reduces the ACB of the policy. The result is that a straight-forward calculation that an individual can easily replicate is not always possible; rather, the insurance carrier needs to separate the premium relative to the type of risk associated with the insurance policy, and to reduce the remaining premium by the amount needed to cover the insurance risk, in order to track the policy’s ACB appropriately.

The adjusted cost basis of an insurance policy is an important figure, but it is a calculation that is generally impossible for the policyholder to perform on his or her own. Whenever a transaction involving the policy takes place, it is important for the policyholder to understand the income tax consequences. Information on the policy’s ACB should be obtained from the insurer before any transactions are undertaken.

E.O. & E.

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Contributors to this edition:

James W. Kraft, cpa, ca, mtax, tep, cfp, clu, ch.f.c.
Deborah Kraft, mtax, tep, cfp, clu, ch.f.c.