The insurance industry is continuing to lobby the federal Department of Finance for clarification of the tax treatment of critical illness insurance return-of-premium options.

The problem has arisen because federal Income Tax Act provisions dealing with life insurance have not been amended to cover CI insurance since the product was introduced in Canada more than 10 years ago. Ted Ballantyne, director of advanced tax policy for the Ottawa-based Conference for Advanced Life Underwriting, says Finance officials “are working on it.”

He hopes to hear from Finance this spring.
“Any discussions I’ve had with them have been positive,” he adds.

In March 2004, CALU and the Toronto-based Canadian Health and Life Insurance Association made a joint submission to Finance and the Canada Revenue Agency asking Ottawa to treat CI insurance policies with returned premiums — on death, expiration of the policy or upon surrender — as non-taxable.

A CI policy provides a client with a lump-sum payment when the client is diagnosed with a specific illness, such as heart attack, stroke or cancer. Under a basic policy without an ROP option, a paid-out benefit would not be taxed. But most CI policies have ROP provisions.

The issue for tax purposes, says Ballantyne, is the characterization of CI insurance when the ROP is included. Tax officials question whether CI policies with ROP provisions should be treated like life insurance policies.

Life policy benefits are generally tax-free, although income generated by premiums is potentially taxable under a complex set of rules in the tax act.

That differs from the treatment of accident and sickness policies, which are purchased annually and do not have ROP provisions.
Nor do they have an investment component and, therefore, no potentially taxable income or interest.

CALU and the CLHIA argue that CI policies should be characterized as accident and sickness policies because premiums are returned without interest. There is no income that has been generated to be taxed.

At the end of 2004, the CRA’s income tax rulings directorate offered some hope. In a Dec. 24 response to a taxpayer’s query, the directorate said that when the purpose of a CI policy is to provide benefits “in the event of a critical illness,” the CRA “has generally taken the position that the policy is a sickness policy.”

The directorate’s response went a step further: “The presence of a ‘return of premium on expiry’ benefit in a CI policy that provides for a benefit that is solely a return of premiums paid in is unlikely, in and of itself, to cause a CI policy to be viewed as having a different character for tax purposes.”

Unfortunately, the directorate’s response came with its usual caveat that, although “believed to be correct,” it may not represent the agency’s “current position.”

The same response was given when tax officials were asked about taxing ROP upon death at the October 2004 conference of the Association de planification fiscale et financière, a Quebec organization for tax, financial and estate planning advisors. “It’s been an interesting year,” says Florence Marino, assistant vice president of tax and estate planning at Manulife Financial Corp.
in Kitchener, Ont., even if Finance has not come out with definitive clarification.

Finance, not the CRA, however, drafts tax legislation. The CRA has provided “some room to manoeuvre,” says Ron Sanderson, the CLHIA’s director of policyholder taxation and pensions, but it wouldn’t want to prevent Finance from making its own interpretation.

“some back and forth”

The CRA is also is looking to Finance for guidance, says Sanderson. CI is a complex product, and Sanderson expects there will be “some back and forth on this, as we get to the right answer.”

About 90% of CI insurance policies are “stand-alone” policies, says Ballantyne.
Otherwise, they are offered as a rider on a life policy or part of an “integrated benefit” universal life policy that pays a CI benefit without affecting the status of the client’s death benefit.

If the tax treatment of stand-alone policies was clarified, it would take care of 90% of policies and the solution could be used as a template to resolve the treatment of other types of CI policies. “We would want to see similar tax treatment for similar benefits,” says Ballantyne.

The CALU/CLHIA submission refers to a 1957 Supreme Court of Canada case known as Gray v. Kerslake. The issue in that case was whether an annuity contract could be characterized as life insurance because the annuity — like CI — provided for ROP on death.