THE UNIQUE NATURE OF A POLICY LOAN

A policy loan is a uniquely defined transaction that can only involve a life insurance policy. The Income Tax Act (ITA) clearly sets out the consequences of a policy loan and its eventual repayment.

The taxation of a policy loan under a life insurance contract was the subject of a recent Tax Court of Canada decision where the taxpayer challenged the CRA’s position that the loan was a taxable event.

The facts of the case were as follows:

• In both 1977 and 1982, Mr. Neszt purchased a life insurance policy on his own life.
• In 2015, Mr. Neszt took out policy loans under each of these two life insurance policies.
• The insurance company issued T5 statements to Mr. Neszt in respect of the two loans on each of his life insurance policies. The T5 amounts resulted in total income of $26,360.

The taxpayer opted not to include the $26,360 amount in his income and the CRA issued a reassessment that included the amount as 2015 income. The taxpayer challenged the reassessment in the Tax Court of Canada on the basis that it was his opinion that a personal loan should not be a
taxable event.

The judge noted that policy loans are governed by specific provisions of the ITA.

• A policy loan is defined as a disposition of an interest in a life insurance policy.
• The gain is the amount of the loan in excess of the adjusted cost basis of the life insurance policy.
• The purpose of these rules is to ensure that a policy holder is taxable on values received from the policy in excess of the adjusted cost basis of the policy.

The judge reaffirmed the CRA’s assessment. He confirmed that the T5 statements issued by the life insurance company were correct.  As noted by the judge, a policy loan is defined as a disposition of an interest in a life insurance contract. A gain is recognized if the proceeds of the disposition, at the time of the policy loan, are in excess of the adjusted cost basis of the policy.

It is worth noting the fact that the policy holder is entitled to a deduction when a policy loan is repaid. The deduction is equal to the lesser of the amount repaid and the gain previously recognized in income.

The ITA contains many specialized provisions that can confound the principles of normal language. As such, it is important for individuals to understand the tax consequences that may arise when undertaking even a simple financial transaction so as to minimize unexpected tax consequences.

 

This commentary is published by The Institute in consultation with an editorial board comprised of recognized authorities in the fields of law, life insurance and estate administration. The Institute is the professional organization that administers and promotes the CLU® and CHS® designations in Canada.

The articles in Comment are not intended to provide legal, accounting or other advice in individual circumstances. Seek professional assistance before acting upon information included in this publication.

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Copyright 2019 ISSN 0382-7038 All Rights Reserved

Authors:
James W. Kraft, CPA, CA, MTAX, TEP, CFP, FEA, CLU
Deborah Kraft, MTAX, LLM, TEP, CFP, CLU
Published by:
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