As part of Budget 2012, unveiled Thursday, the Canadian government is proposing a number of key changes to the test it uses to determine which life insurance policies are to be considered exempt policies, and therefore exempt from accrual taxation on the income earned in the savings portion of the policy.
The purpose of the exemption test is to differentiate protection-oriented life insurance policies from investment-oriented insurance policies. The government said that after a review of the current legislation regarding the exemption test, which was first introduced in the early 1980s, it decided that several technical changes were needed to update and simplify the test.
However, the proposed changes may also be addressing the issue of certain life insurance policies — so-called “single premium” or “quick pay” policies — that have increased in popularity since the introduction of the exempt test 30 years ago, says Jamie Golombek managing director of tax and estate planning with CIBC Private Wealth Management.
“The government may have been concerned that the exempt test as it currently stands permitted overly advantageous tax deferral beyond the original intention of the exempt test,” Golombek says.
A life insurance policy is an exempt policy when the savings accumulating in the policy does not exceed the savings in a benchmark policy. Depending on the type of coverage, the savings in the benchmark policy are calculated using prescribed mortality and interest rates, the rates used in determining the premiums, or the cash surrender value of the actual policy.
The savings in an actual policy are measured using an amount that is equal to the greater of the cash surrender value of the policy and the modified net premium reserve in respect to the policy. The benchmark policy is generally defined as a policy where the death benefit is payable on the earlier of death and the age of 85 (the endowment time) and premiums are payable 20 years after the issuance of the policy (the pay period).
As part of the 2012 budget, the government proposes to implement the following changes to the exemption test:
> The savings in an actual policy and the benchmark policy will be measured using the Canadian Institute of Actuaries 1986-1992 mortality tables and an interest rate of 3.5% to better reflect mortality rates and investment returns while improving consistency between the measurement of the savings in an actual policy and the measurement of the savings in the benchmark policy;
> The endowment time of the benchmark policy will be increased to age 90 from age 85 to reflect increased life expectancy;
> Savings in an actual policy will be measured using the greater of the cash surrender value of the policy (before the application of surrender charges) and the net premium reserve in respect to the policy to capture all savings in an actual policy while improving consistency between the measurement of the savings in the policy and the measurement of the savings in the benchmark policy;
> The pay period of the benchmark policy will be reduced to eight years from 20 years to better reflect current industry practices and the pay period used in other countries.
In addition, the budget proposes that the investment income tax levied on life insurers be recalibrated, where appropriate, to neutralize the effects of the proposed technical improvements on the IIT base.
The government says it will consult, over the coming months, with key stakeholders regarding the proposed technical improvements and the recalibration of the IIT base. Amendments to the tax provisions arising out of these consultations will apply to life policies issued after 2013.