taxation of life insurance - ctf.ca · for the taxation of life insurance in 1968, major...

1506 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE

(1995), Vol. 43, No. 5 / no 5

Taxation of Life Insurance

William J. Strain, FCA*

PRÉCIS

L’élaboration d’un régime fiscal équitable pour les sociétés d’assurance-vie et les titulaires de polices constitue un défi pour les responsables del’élaboration de politiques fiscales partout dans le monde. Le secteur del’assurance-vie comporte de nombreuses questions épineuses, y comprisla nature éventuelle à très long terme d’une police d’assurance-vie, si, ouiou non, du point de vue d’une politique sociale, les gains de mortalitédevraient être imposés, si le revenu tiré du placement des réserves autitre des polices devrait être imposé et, le cas échéant, s’il doit l’être dansles mains du titulaire de police ou dans celles de la société d’assurance. Ilexiste d’autres complications en raison du caractère multinational dusecteur canadien de l’assurance-vie et du fait que presque la moitié del’assurance-vie au Canada est fournie par des sociétés mutuellesd’assurance sur la vie, lesquelles sont détenues entièrement par lestitulaires de polices. Ces facteurs entre autres ont eu une influenceconsidérable sur l’évolution du régime canadien d’imposition del’assurance-vie.

Avant 1968, les sociétés d’assurance-vie et les titulaires de policeétaient presque exemptés d’impôt. Depuis l’adoption d’une structureofficielle pour l’imposition de l’assurance-vie en 1968, des initiativesmajeures de «réforme» ont été entreprises en 1977, en 1981, en 1987, en1992 et en 1995. Nombre des propositions contenues dans ces réformesn’ont pas été mises en place ou ont été adoptées sous une formeconsidérablement modifiée après une consultation auprès du secteur del’assurance-vie.

Cette chronologie de l’imposition de l’assurance-vie au Canada s’inscritdans le contexte du secteur en évolution depuis les dernières décennieset de la récente révolution dans l’élaboration de produits d’assurance-vie.D’une part, les changements survenus dans le secteur ont influencéconsidérablement l’élaboration des politiques fiscales et, d’autre part, lesinitiatives en matière de politiques fiscales ont largement influencé lesecteur et l’élaboration de produits en particulier.

En tenant compte des racines et des tendances passées del’élaboration de l’imposition de l’assurance-vie, l’auteur conclut enprésentant certaines observations sur ce que pourrait réserver l’avenir.

1506 (1995), Vol. 43, No. 5 / no 5

* Of PPI Financial Group, Toronto.

TAXATION OF LIFE INSURANCE 1507

(1995), Vol. 43, No. 5 / no 5

ABSTRACTDesigning a fair tax system for life insurance companies and policyholders has long been a challenge for tax policy makers around theworld. There are many difficult issues peculiar to the life insuranceindustry, including the very long-term contingent nature of a lifeinsurance policy, whether or not mortality gains should be taxed from asocial policy perspective, whether the income earned from theinvestment of policy reserves should be taxed and, if so, whether itshould be taxed in the hands of the policy holder or the insurancecompany. Further complications arise because of the multinationalcharacter of the Canadian life insurance industry and the fact that almosthalf of all insurance in force in Canada is provided by mutual life insurers,which are owned entirely by their policy holders. These and other factorshave had a significant influence on the development of the Canadiansystem of taxation of life insurance.

Before 1968, life insurance companies and their policy holders werevirtually exempt from tax. Since the introduction of a full-fledged structurefor the taxation of life insurance in 1968, major “reform” initiatives wereundertaken in 1977, 1981, 1987, 1992, and 1995. Many of these reformproposals either were not implemented or were introduced in substantiallymodified form after consultation with the life insurance industry.

This chronology of life insurance taxation in Canada is set in thecontext of the changing industry over the past decades and the recentrevolution in life insurance product design. Changes in the industry havehad a significant influence on the development of tax policy; by the sametoken, tax policy initiatives have had a significant influence on theindustry and on product development in particular.

Reflecting on the roots of and past trends in the development oftaxation of life insurance, the author concludes by offering someobservations on what the future might hold in store.

These are interesting times for the life insurance industry in Canada. Thesevere recession that began in 1990, triggering the collapse of real estatemarkets across North America, has taken its toll on the industry. Thefailure of a few life insurance companies over the past few years hasfocused attention and sparked widespread debate on solvency, consumerprotection, and regulatory issues.

The deregulation of the financial services sector, begun in the late1980s, resulted in a tidal wave of restructuring in the banking, trust, andbrokerage industries. The restructuring wave rolls on, and is likely toengulf the life insurance industry throughout the remainder of the decadeas the last barriers to entry by other financial institutions come down.

Despite tough economic times and the rapidly changing financial serv-ices marketplace, the Canadian life insurance industry remains strong. Withinvestments of over $170 billion at the end of 1993, the industry is a


(1995), Vol. 43, No. 5 / no 5

powerful force in the nation’s economy. Canadians rely heavily on indi-vidual and group life insurance. At the end of 1993, Canadians owned over$1.4 trillion of life insurance, more than triple the amount owned in 1980.1

As the population ages and as governments at all levels cut back onincome support and other social programs, people are becoming increas-ingly concerned about their long-term financial security. The demand fornew and innovative financial products and services to address these con-cerns is strong and growing.

The taxation of life insurance companies and policy holders has aprofound impact on the evolution of the industry and the creation of newproducts. In this, the 50th anniversary year of the Canadian Tax Founda-tion, it is timely to pause and reflect upon the development of Canada’ssystem for the taxation of life insurance over the past 50 years.

This article focuses primarily on the taxation of the policy holder.However, policy holder and company tax issues are interdependent. Con-sequently, reference is also made to the tax system for life insurancecompanies as it interrelates with policy holder taxation. This historicalreview is set in the context of the changing industry and, in recent years,the revolution in life insurance product design.

There are valuable lessons to be learned from examining the roots andpast trends in the development of the tax system for life insurance. Re-flecting on the past may provide at least some hints as to the directionand extent of possible tax changes that will have a significant influenceon the life insurance industry as it moves into the 21st century.

TAX POLICY CHALLENGESThe very long-term nature of the contractual commitments between thepolicy holder and the life insurance company creates difficult technicalchallenges in designing a fair and equitable tax system for life insurancecompanies and policy holders. A fundamental and highly charged politi-cal question is whether life insurance, which provides for the financialsecurity of a deceased’s dependants or indemnifies financial obligationsand losses arising on death, is properly the subject of taxation.

The peculiar difficulties of taxing life insurance companies and policyholders have bedevilled tax policy makers around the world for manyyears. The Canadian experience is no exception. To set the stage for thehistorical review of the taxation of life insurance, the following sectiondescribes the tax policy implications arising from the distinguishing char-acteristics of life insurance.

The Long-Term Contingent Nature of Life InsuranceA life insurance policy is a contract between a policy holder and aninsurance company whereby, in consideration for the payment of speci-

1 Canadian Life and Health Insurance Association, Canadian Life and Health InsuranceFacts, 1994 ed. (Toronto: CLHIA, 1994), 5.


(1995), Vol. 43, No. 5 / no 5

fied premiums, the insurance company agrees to pay to a designated ben-eficiary a certain sum at a specified future time or upon the happening ofa specified contingency, usually related to survival of the person whoselife is insured.2 The policy is a contractual commitment on the part of theinsurer that extends over many years. To put the long-term nature of thelife insurance commitment into perspective, consider that a permanentpolicy issued on the life of a 30-year old when the Canadian Tax Founda-tion was established 50 years ago may just now be approaching maturity.

Determining profit on an annual basis for the purposes of imposing anincome tax is problematic for any business. To some degree, interperiodallocations of revenues and expenses are required for all businesses toproperly match revenues with the costs necessarily incurred to earn suchrevenues and to reasonably apportion the income earned over the busi-ness cycle. Nowhere is this challenge more formidable than in the lifeinsurance industry. The annual determination of profit for a life insurancebusiness involves a process of estimating expected mortality, investmentreturns, and expenses over many years. The very essence of the life insur-ance business is the indemnification of contingent future liabilities. Tocalculate income, it is not only necessary to estimate the absolute amountof the contingent liability but also to determine when the liability will falldue so that its present value can be estimated.

Mortality Gains and LossesInsurance is a business of risk intermediation. Life insurance providesfinancial protection against the risk of mortality over a period of time.The insurance company operates as an intermediary, pooling the risks ona large number of lives either directly or through reinsurance arrange-ments with other companies.

Where a contract is issued on a yearly renewable term (YRT) basis, thepremium, after a margin is deducted for expenses and profit, representsthe amount that is required to pay claims. Over the whole insured popula-tion, there should not be a net mortality gain or loss. However, individualpolicy holders will receive either more or less than they contribute to therisk pool.

Theoretical tax policy considerations aside, legislators ignore at theirperil the social and political ramifications of taxing life insurance pro-ceeds. Strong arguments can be made that individuals should be encour-aged to provide for their own and their families’ protection. The rationalefor taxing insurance proceeds received on death is difficult to explain,particularly at a time when beneficiaries are suffering a tragic sense ofpersonal loss and financial insecurity.

2 Various contractual requirements are prescribed pursuant to the provisions of applica-ble provincial insurance legislation. The provincial legislation reflects the so-called UniformLife Insurance Act adopted by all common law provinces. The provincial legislation inQuebec is broadly similar to the insurance law of the common law provinces.


(1995), Vol. 43, No. 5 / no 5

The co-operative nature or mutuality of the insurance arrangement isevident from the fact that almost half of the life insurance in force inCanada at the end of 1993 was provided by mutual life insurance compa-nies, owned entirely by their policy holders.3 Both mutual and stockcompanies can issue participating and non-participating insurance inCanada. Premiums for participating insurance are higher than those forinsurance written on a non-participating basis. However, participatingpolicy holders share in favourable mortality, expense, and investmentexperience by way of policy dividends.

Important questions must be addressed by the tax policy makers. Forexample:

1) Are mortality gains and losses realized by individual policy holdersproperly included in the tax base?

2) Should policy dividends be treated as a return of excess premiumsor as a distribution of the insurance corporation’s after-tax income?

3) What provisions are necessary to ensure that the tax system doesnot create a bias between a mutual company, owned by its policy holders,and a stock company, owned by its shareholders?

Savings Versus ProtectionThe pure cost of insurance increases exponentially with age. On a YRT basis,the cost of maintaining permanent life insurance increases dramatically overtime and becomes prohibitive at older ages. As an alternative to ever-increasing premiums, the insured may choose to pay a level premium toaverage out the pure cost of insurance evenly over the term of the contract.

Whether the policy covers a specified term or provides permanent cov-erage, premiums are almost always paid according to a schedule thatresults in the amounts paid during the early years of the contract exceed-ing the pure mortality cost for those years. Premiums paid in excess ofthe related mortality costs and expenses are accumulated and invested bythe insurance company. This accumulating investment fund represents areserve held by the insurer to back the obligations to policy holders. Atthe end of 1993, Canadian life insurance companies held reserves ofapproximately $25 billion backing individual life insurance policies.4

The reserves affect the pricing and performance of a policy in twoways. First, in the later years of a policy when the premiums are notsufficient to cover the mortality cost, the shortfall can be drawn downfrom the policy reserve. Second, the reserve is available to pay a claimunder the policy. Consequently, the “net amount at risk” under the policyis reduced, thereby reducing the cost of insuring that risk.5

3 Supra footnote 1, at 34.4 Ibid., at 31.5 For a more comprehensive description of the interrelationship between the savings and

protection elements of a life insurance policy, see William J. Strain, “Life Insurance: An(The footnote is continued on the next page.)


(1995), Vol. 43, No. 5 / no 5

Many permanent insurance policies are designed so that the accumu-lating fund grows over time to equal the total amount of the benefitpayable on death. At that time, the net amount at risk under the policy iscompletely eliminated and the policy is said to endow.

Under most permanent life policies, there is a direct relationship be-tween the accumulating fund held by the insurer and the cash surrendervalue (CSV) of the policy. The CSV is the amount the policy holder isentitled to receive upon the cancellation or surrender of the policy. Withina few years after issue, the CSV of the policy typically approximates thevalue of the related accumulating fund.

Following the introduction of the “term to 100” concept in the early1980s, an increasing number of permanent policies have been designedwith CSVs significantly less than their related accumulating funds. Sim-ply stated, term-to-100 is a permanent life insurance policy, generallyhaving guaranteed level premiums until age 100 and a guaranteed deathbenefit, but little or no cash value. Where such a policy is surrendered orlapses because of the non-payment of premiums, the excess of the accu-mulating fund over the CSV is forfeited by the policy holder and becomesavailable to pay the claims of other policy holders. The expected forfeituresare factored into the pricing of such policies and premiums are reducedaccordingly. This type of policy is referred to as “lapse-supported.”

The description of a life insurance policy as comprising distinct pro-tection and savings components has long been a convenient but simplisticway to describe the complex nature of the contractual arrangements be-tween the insurer and the policy holder.6 In reality, a life insurance policyis a unified contract with the insurance and savings elements inextricablylinked. The financial consequences to the policy holder will depend onwhether the policy is retained and, if so, when and in what circumstancesbenefits are paid. Furthermore, the policy holder cannot ordinarily with-draw any of the cash values of the policy without adversely affecting thevalue of the insurance protection. Ultimately, the financial results emergeover a very long period.

The conundrum of whether permanent life insurance represents de-creasing term insurance coupled with an increasing savings account orthe purchase of insurance protection on an instalment payment plan ishighlighted in figure 1 and figure 2.7 Both of these illustrations reflect a

Innovative Financial Instrument,” in Report of Proceedings of the Forty-Fifth Tax Confer-ence, 1993 Conference Report (Toronto: Canadian Tax Foundation, 1994), 35:1-34, at 35:3-5.

6 A detailed analysis of a life insurance policy divided into two economic componentsfirst appeared in M. Albert Linton, “Analysis of the Endowment Premium,” ActuarialNotes feature (1919), 20 Actuarial Society of America: Transactions 430-43.

7 The conception of a life insurance policy as comprising two distinct elements ofprotection and savings was challenged in Robert I. Mehr, “The Concept of theLevel-Premium Whole Life Insurance Policy—Reexamined” (September 1975), 42 TheJournal of Risk and Insurance 419-31.

5 Continued . . .


(1995), Vol. 43, No. 5 / no 5

0

$200

$400

$600

$800

$1,000

$1,200

1009590858075706560555045

Reserve

Net amount at risk

Age

Tho

usan

ds

Figure 1 $1 Million Permanent Life Insurance Policy(Endow at Age 100)

8 The insurance illustration is based on “Security Fund,” a universal life policy offeredby the Prudential of America Life Insurance Company (Canada). The interest rate creditedto the accumulating fund of the policy is assumed to be 6.5 percent annually. Annualpremiums are assumed to be payable until the insured’s age 100.

$1 million permanent life insurance policy issued on a 45-year-old malenon-smoker. The policy shown in figure 1 has been designed to grow theCSV to an amount equal to the face amount of the policy at age 100 (theclassic illustration of the decreasing term/increasing savings scenario).The policy shown in figure 2 has been designed to build a reserve justsufficient to defray future mortality costs and expenses so that the policywill lapse without value at age 100.

The annual premium required to fund the policy shown in figure 1 is$12,555, compared with an annual premium of $12,515 required to fundthe policy shown in figure 2. The difference is only $40 per year.8

The situation is further confused by the fact that the financial resultsmay differ considerably from those illustrated, depending on the actualamount of policy dividends or interest credited to the accumulating fundsand the actual amount of mortality costs and expenses charged under thecontract. In fact, the policy shown in figure 1 could actually lapse with-out value, or the policy shown in figure 2 could actually endow.


(1995), Vol. 43, No. 5 / no 5

0

$200

$400

$600

$800

$1,000

$1,200

1009590858075706560555045

Reserve

Net amount at risk

Age

Tho

usan

dsFigure 2 $1 Million Permanent Life Insurance Policy

(Lapse at Age 100)

The trouble is, in that mystical and magical world of actuarial science,what may or may not be 2, when multiplied by a factor that may or may notbe 2, could possibly turn out to be 4, but probably will not!

The relationship between the savings and protection elements of a lifeinsurance policy raises the following tax policy questions:

1) Should the income earned from the investment of the policy re-serves be subject to tax? If so, when?

2) If the investment income is to be taxed, should it be taxable in thehands of the insurance company or the policy holder?

3) If taxable in the policy holder’s hands, how is the investment in-come earned by the insurance company to be allocated among policyholders?

Level Playing FieldThe financial products and services provided by the life insurance indus-try may compete either directly or indirectly with financial products andservices offered by other financial institutions. As the barriers separatingthe traditional pillars of the financial services sector have come down, therange of products and services offered by each type of financial institu-tion has been significantly expanded. The tax policy maker must struggle


(1995), Vol. 43, No. 5 / no 5

to ensure that the tax system does not create an unfair competitive advan-tage for one financial institution over another.

Regulatory Versus Tax Policy IssuesThe life insurance industry is closely regulated because of public concernover the protection of policy holders and the stability of the country’s fi-nancial institutions. The objectives of the regulatory authorities and thoseof the tax system are in conflict. How can such conflicting objectives bereconciled? For example, does a restriction on the deductibility of actuarialreserves by a life insurance company impair the strength of the company?

Product Innovation and DevelopmentFifty years ago, the development of a new life insurance product was amammoth undertaking that required an incubation period of many yearsfrom conception to delivery. Today, the lead time for bringing a newproduct to market has shrunk to a matter of months. The challenge for thetax policy maker is to design a system that is based on sound fundamentalprinciples and that is sufficiently flexible to adapt to a rapidly changingmarketplace. The tax system should not impede new product innovationeither by imposing a set of complex and detailed technical rules or bycreating an unnecessary air of uncertainty over the application of therules to new and innovative products.

It is against this backdrop of tax policy issues and challenges that theevolution of Canada’s system for the taxation of life insurance is examined.

BEFORE CARTERIndustry EnvironmentDuring the 20 years between the Canadian Tax Foundation’s establish-ment in 1945 and the mid-1960s, the Canadian life insurance industrycould perhaps best be described as staid, conservative, and steeped intradition. The industry was dominated by a relatively small number oflarge companies offering a narrow range of products. The products soldthroughout this period included mainly whole life (participating andnon-participating), limited pay life, endowment, and term policies. In1960, whole life accounted for almost 75 percent of all individual lifeinsurance owned by Canadians.

Product pricing was typically based on level premiums fixed at thetime the policy was issued. The amount of death benefit was ordinarilyestablished at the time of issue and remained unchanged throughout theduration of the contract. The CSV of the policy at any point in the term ofthe contract could be determined at the time the policy was issued. Newproduct introductions were rare, and existing products were repriced onlyevery 5 to 10 years.

The policies were characterized by complex contractual language, lit-tle disclosure of the design elements or factors involved, and very limitedflexibility or available options.


(1995), Vol. 43, No. 5 / no 5

Tax SystemLife insurance was virtually exempt from income tax at both the companyand the policy holder level until 1968. The Income War Tax Act of 1917,the first income tax statute in Canada, provided an explicit exemption forpolicy holders on

the proceeds of life insurance policies paid upon the death of the personinsured, or payments made or credited to the insured on life insuranceendowment or annuity contracts upon the maturity of the term mentionedin the contract or upon the surrender of the contract.9

A tax exemption was also provided for the income of life insurancecompanies “except such amount as is credited to shareholders’ account.”10

Consequently, only the net earnings of stock life insurance companieswhich were allocated to shareholders (whether or not distributed) weresubject to corporate income tax. Mutual life insurance companies, havingno shareholders, were fully exempt.

When the Income War Tax Act was overhauled in 1948, this sameprinciple was carried forward. However, the explicit exemption was with-drawn. Instead, the exemption was implicit in the definition of the taxableincome of a life insurance company, which included only amounts cred-ited to the shareholders’ account.11

The specific exemption for life insurance proceeds received by a policyholder was also dropped in the new Income Tax Act in 1948. However,the minister of finance, Douglas C. Abbott, stated in the House of Com-mons that “[t]here is this privilege, that earnings of life insurance policiesare exempt from taxation, and properly so.”12 On the basis of this phi-losophy, gains realized on death, maturity, or surrender of life insurancepolicies were not taxable before 1969.

Beginning in 1940, life annuities became taxable in full. However,only the interest element of annuities that were issued for a specifiedperiod was subject to tax. Life annuities with guaranteed periods weretaxable only on the interest element during the guaranteed term but on thefull amount thereafter. This procedure raised a public outcry of dissatis-faction and led to the appointment of a royal commission on the taxationof annuities. The Ives commission recommended that annuities be taxedon the principle that a portion of each payment is in part a tax-free returnof capital and in part taxable interest income. A simple rule of thumb wasadopted to calculate the tax-free capital element to be the level amountobtained by dividing the purchase price by the term (in years) or, in thecase of life annuities, by the expectation of life.13 These recommendations

9 SC 1917 c. 28, section 3(1).10 RSC 1927, c. 97, section 4(g).11 Income Tax Act, SC 1948, c. 52, section 29.12 Canada, House of Commons, Debates, June 1, 1948, 4639.13 Canada, Report of the Royal Commission on the Taxation of Annuities and Family

Corporations (Ottawa: King’s Printer, 1945).


(1995), Vol. 43, No. 5 / no 5

for the taxation of annuities were adopted in 1945 and survive today asthe basis for the taxation of prescribed annuities.

Although the interest element of annuity payments was taxable, therewas no provision in the legislation to tax the proceeds received on thesurrender of a deferred annuity contract before the commencement ofperiodic payments. This loophole eventually led to a widespread practiceof purchasing deferred annuities with the intention of cancelling thembefore maturity in order to receive tax-free gains. In 1963, the IncomeTax Act was amended to block this perceived abuse by taxing as interestincome any gain realized on the surrender of an annuity contract, otherthan on death.14

THE 1960SIndustry EnvironmentDuring the 1960s, the winds of change began to blow through the lifeinsurance industry. The economic climate was undergoing a fundamentalchange as interest rates started to rise, fuelled by intensifying inflationarypressures. Life insurance policy holders were becoming increasingly dis-enchanted with traditional permanent insurance as an investment. Moreand more whole life policy holders were advised to buy term and investthe difference. By the end of the decade, the percentage share of theindividual life insurance market represented by whole life policies haddropped from about 75 percent to just over 60 percent.

The availability of increasing computing power permitted the fasterdevelopment and maintenance of new and more complex products. Thepricing of existing products was also changed more frequently in re-sponse to changing economic conditions. Insurance mortality rates wereimproving with advances in medical science and health care, resulting inlower insurance costs. Competition within the industry was also intensi-fying as new and smaller companies entered the market and moreforeign-owned insurance companies ventured into Canada. These newerentrants into the market could afford to pursue market share by develop-ing new and competitive products without the concern about their possibleimpact on existing blocks of in-force business.

Tax System“Yesterday, all my troubles seemed so far away.”

—Paul McCartney, 1965

By 1962, Canada’s tax system was sadly in need of repair. Corporate “sur-plus stripping” had become an issue of major concern. Literally dozens oftechniques had been designed to enable shareholders to convert taxabledividend distributions into tax-free capital gains realized on the disposi-tion of shares. The government feared that these and other “tax-planning”

14 SC 1963, c. 21, section 3, adding subsection 7(5) to the Income Tax Act, RSC 1952,c. 148, as amended.


(1995), Vol. 43, No. 5 / no 5

strategies were threatening to seriously undermine the integrity of the entirestructure. A royal commission on taxation (the Carter commission) wasappointed to investigate and make recommendations for improvements.After an exhaustive inquiry, the Carter report was released in 1966, rec-ommending that the government scrap the existing system, start over, andcreate an entirely new tax structure built on the commission’s concepts ofequity and neutrality.15

The Carter report was a watershed in the evolution of tax policy inCanada. The commission forever changed the environment for the taxa-tion of life insurance. Particular recommendations put forward in theCarter report must be considered in the context of the full integratedmodel tax system proposed by the commission. Simply stated, a funda-mental guiding principle for the new tax system was that taxes should beimposed according to a person’s ability to pay.

It is our view that the adoption of the comprehensive tax base we recom-mend would greatly improve taxpayer equity by bringing virtually allincreases in economic power into tax. Such a tax base would also have thevery desirable ancillary benefit of substantially eliminating the uncertainty,and the various opportunities for tax minimization and avoidance, that wehave found in the present system, because virtually all net gains would betaxable to residents at full personal rates.16

On the basis of this “a buck is a buck” concept of the tax base, thecommission’s recommendations for the taxation of life insurance shouldnot have come as any great surprise. In summary, the commissionrecommended:17

1) Life insurance companies should be taxed at regular corporate rateson operating income not passed through to policy holders. However,through the gross-up and credit mechanism proposed for taxing dividendincome, the corporate tax rate would ultimately be adjusted to the per-sonal tax rates of individual shareholders. A similar process should applyto mutual insurance companies with respect to gains held for the benefitof participating policy holders.

2) Premiums paid for a life insurance policy (other than for employer-sponsored group life insurance) should not ordinarily be deductible incomputing taxable income.

3) In general, investment income accumulated for the benefit of thepolicy holder should be included in the policy holder’s income in the yearit is accumulated in the hands of the insurer. The commission recognizedthat the feasibility of this recommendation depended on “finding a proce-dure which is satisfactory from the points of view of both equity and ease

15 Canada, Report of the Royal Commission on Taxation (Ottawa: Queen’s Printer,1967) (herein referred to as “the Carter commission” or “the Carter report”).

16 Ibid., vol. 3, at 71.17 Ibid., vol. 4, at 432-33.


(1995), Vol. 43, No. 5 / no 5

of computation for allocating to individual policyholders the investmentincome credited to policy reserves.”18

As an alternative, the commission proposed a system of withholdingtaxes under which the insurer would pay tax on investment income cred-ited to policy reserves when accrued; the policy holder would receive acredit at the time benefits were paid (the blueprint for the investmentincome tax).

4) Policy dividends should be included in the income of the recipient.

5) Mortality gains and losses should eventually be included in thecomputation of the income of policy holders. However, the commissiondid not recommend the immediate inclusion of mortality gains and lossesin the tax base, primarily because the other recommendations involvedsuch a substantial change in the tax treatment of life insurance.

The life insurance industry was the first to feel any real impact fromthe Carter report. In his 1968 budget, Finance Minister Edgar Bensonproposed a full-fledged structure for the taxation of life insurance. Al-though they did not go nearly as far as the Carter commission recom-mended, the 1968 proposals nevertheless represented radical change. Twonew separate taxes were proposed, one at the policy holder level and oneat the corporate level. When introducing these proposals, Finance Minis-ter Benson said:

It is essential as well, I believe, in terms of equity between those who savein the form of insurance policies and those who save in other forms, to levysome tax on the investment income which policyholders receive throughthe insurance companies.19

Mr. Benson also said that his proposals would constitute “a much simplerand more practical method” than the method recommended by the Cartercommission, and should “achieve substantially similar equity.”20

After intensive consultation with the life insurance industry, the budgetproposals were implemented, with some modifications, through amend-ments to the Act and the regulations in 1969. The new taxes on lifeinsurance introduced in 1969 are summarized below.

Policy Holder GainsGains realized by a policy holder on the surrender or maturity of a lifeinsurance policy (but not on death) became fully taxable. The accumu-lated policy reserves, when received as part of the benefit payable upondeath, continued to be tax-free, as were pure mortality gains. Carter’srecommendation to tax income credited to policy reserves in the hands ofpolicy holders on an accrual basis was rejected.

18 Ibid., vol. 3, appendix C, at 585.19 Canada, Department of Finance, 1968 Budget, Budget Speech, October 22, 1968, 11.20 Ibid.


(1995), Vol. 43, No. 5 / no 5

The amount to be included in taxable income upon the disposition of apolicy was the excess of the proceeds over the adjusted cost basis (ACB)of the policy holder’s interest in the policy. Generally, the ACB was theaggregate of premiums paid. Policy dividends were treated first as a re-duction of the ACB and therefore were not currently taxable until suchtime as the total dividends received exceeded the total premiums paid oruntil the policy was surrendered or matured (other than as a consequenceof death).

Special grandfathering treatment was accorded to life insurance poli-cies that were in force on October 22, 1968, to avoid retroactive taxationof gains already accrued.

Segregated FundsA segregated fund policy is a variable life insurance contract under whicha portion of the premium is placed in a separately administered invest-ment portfolio. The proceeds receivable by a policy holder under such apolicy at any time will depend on the value of the securities held in thesegregated fund.

At the urging of the life insurance industry, the government adopted aflowthrough treatment for segregated fund policies. Provision was madefor the insurer to allocate investment income earned on the segregatedfund to the policy holder on an annual basis. The character of the invest-ment income as dividends, interest, and income from other sources waspreserved and taxed as such in the policy holder’s hands. The proportion-ate amounts of foreign taxes paid and depletion allowances were alsoallocated and made available to policy holders as credits and deductions.

The flowthrough treatment for segregated funds was intended to estab-lish a level playing field with the mutual fund industry for investmentproducts that were substantially similar in nature.

Investment Income TaxIn 1968, the government had concluded that there was no “simple andpractical method of taxing in the policyholders’ hands the investmentincome which benefits them by way of reduced premiums or increasedpolicy dividends.”21 To take the place of a tax on the individual policyholders, a 15 percent tax was imposed on the taxable Canadian invest-ment income of the insurance companies. The calculation of this investmentincome tax (IIT) was not simple and, in many respects, was very arbitrary.

The starting point was to allocate gross investment income betweenCanadian and foreign life insurance operations (excluding income relatedto segregated funds, registered retirement funds, and grandfathered poli-cies). Deductions were then allowed for investment expenses and a purelyarbitrary 50 percent of the company’s general expenses incurred in itsCanadian operations (including commissions but excluding premium taxes).

21 Ibid.


(1995), Vol. 43, No. 5 / no 5

The 50 percent factor was intended to deny a deduction for those ex-penses related to the risk element of the life insurance business.

Amounts received by policy holders representing the taxable elementof annuity payments and taxable gains realized on the surrender or matu-rity of policies were deducted in calculating taxable Canadian investmentincome. The result of this deduction was that the company recovered thetax it paid on investment income when such amounts became taxable tothe policy holder. A deduction was also allowed for the amount of incomesubject to regular corporate income tax.22

Corporate Income TaxThe 1969 amendments brought insurance companies into the tax net forthe first time: the amendments provided that:

1) All insurance companies, both stock companies and mutual compa-nies and life and non-life companies, were deemed to be carrying onbusiness for profit.

2) All premiums were deemed to be received in the course of business.

3) All investment income was deemed to be income of the corporation.

4) Income and taxable income was determined according to rules ap-plicable to all other corporations, except as otherwise provided.23

The special provisions applicable to life insurance companies includedthe following.

Canada-Only PrincipleOnly income earned from carrying on a life insurance business in Canadawas subjected to tax.24 This principle, which continues today, is a signifi-cant departure from the normal approach of taxing Canadian-resident com-panies on their worldwide income and allowing credits for foreign taxespaid. Here again, extraordinarily complex and often arbitrary rules weredeveloped to allocate income between Canadian and foreign operations.

In adopting the Canada-only approach for life insurance companies,the government recognized that many companies operated internationallythrough foreign branches. Such companies may have been placed at asevere competitive disadvantage if a worldwide basis of taxation wereabruptly imposed.

Capital GainsThe 1969 amendments specifically provided that the investment incomeof a life insurance company would include realized gains and losses andthe amortization of premiums and discounts on “Canada securities”—

22 SC 1968-69, c. 44, section 28, adding sections 105R to 105U to the Act.23 Ibid., section 15, adding section 68A to the Act.24 Ibid., adding subsection 68A(2) to the Act.


(1995), Vol. 43, No. 5 / no 5

mainly bonds, debentures, and mortgages, but not equities.25 For mostother companies, such amounts were considered capital gains or lossesand consequently were not taxable.

Policy ReservesRegulations were developed in 1969 to determine the maximum tax actu-arial reserves (MTAR) allowable in calculating a life insurance company’sincome for tax purposes.26 The MTAR were not necessarily the same asreserves reported in the company’s annual filings with the federal regula-tors. The government was concerned that the statutory reserves wereultraconservative and would result in a significant understatement of in-come if allowed for tax purposes.

Reserves for life insurance policies (and individual deferred annuities)with guaranteed cash values were based on the net level premium method,using the same mortality and interest assumptions implicit in the determi-nation of the cash values. Reserves for other policies were calculatedpursuant to the net level premium method, using the same interest andmortality assumptions as used for statement reserves. In general, reservesfor annuities (other than deferred annuities with guaranteed cash values)were calculated using the same mortality tables and at interest rates 1 per-cent lower than those used in calculating premiums.

The life insurance industry made strong representations to the govern-ment and the Senate Finance Committee for the allowance of additionalcontingency reserves. Industry representatives sought recognition of thehighly contingent nature of mortality risks and the potential of experienc-ing adverse results with regard to investment yields and expenses overthe long-term duration of a life insurance contract. However, the govern-ment did not agree; in its view, there was already some margin forcontingencies in the MTAR, and other types of corporations are not per-mitted deductions for contingency reserves. The government also felt thatthe effects of any unusual losses could be cushioned by an effectiveunlimited carryforward of losses available to life insurance companiesthrough their discretionary ability to claim as a deduction any amount ofpolicy reserves up to the MTAR.

Policy DividendsDividends paid to the owners of participating life insurance policies weredeductible, subject to specified limits.27 In general terms, the limit was thepre-dividend, pre-tax earnings from the individual and group participating

25 Ibid., adding paragraph 68A(4)(b) to the Act.26 Ibid., adding subparagraph 68A(3)(a)(i) to the Act and SOR/69-628 (1969), vol. 103,

no. 24 Canada Gazette Part II 1764-76, adding regulations 1400 and 1401. (Unless other-wise stated, all references to regulations in this paper are income tax regulations madepursuant to the Income Tax Act.)

27 SC 1968-69, c. 44, section 15, adding subparagraph 68A(3)(a)(iv) to the Act.


(1995), Vol. 43, No. 5 / no 5

life business. The deduction was available in advance in the form of a reservefor future policy dividends that were payable out of current earnings.

Deduction for Investment Income TaxThe IIT was allowed as a deduction in computing income subject to thebasic corporate tax.28 Because the amount of such income was also de-ductible in determining the base on which the IIT applied, the determinationof each level of tax required a complex circular calculation.

Dividends Paid to ShareholdersBefore 1969, tax was payable by stock life insurance companies on divi-dends paid or credited to shareholders. To preserve continuity and toensure that large accumulations of surplus before 1969 did not escapetax, the 1969 amendments provided that subsequent dividends would alsotrigger corporate tax to the extent that they exceeded earnings accumu-lated after the new system was implemented.29

THE 1970SIndustry EnvironmentEconomic ConditionsThe 1970s brought rapidly increasing interest rates, runaway inflation,and high budget deficits. The average yield on long-term Canada bonds,just under 7 percent in 1970, rose steadily throughout the decade to over11 percent by 1979. The average annual increase in the consumer priceindex, around 3 percent in 1970, hit double digits in 1975 before retreat-ing to just over 9 percent by 1979.

These conditions caused policy holders to question whether traditionallife insurance policies offered sufficient economic sensitivity and flex-ibility. Sales of both participating and non-participating whole lifeinsurance policies began to dry up as consumers perceived better finan-cial returns available through other savings and investment products. Atthe end of 1979, more than half of all individual life insurance owned byCanadians was in the form of term policies.30

Insurers also began to experience cash flow problems as dissatisfiedpolicy holders either surrendered their policies or took out policy loans atinterest rates substantially below market. Inflation was also driving upoperating costs at a time when premium income was either static or fall-ing for some companies.

Product DevelopmentTo compete in a dynamic and rapidly changing investment climate, the tra-ditional participating and non-participating whole life insurance products had

28 Ibid., adding subparagraph 68A(3)(a)(vii) to the Act.29 Ibid., adding subsection 68A(7) to the Act.30 Supra footnote 1, at 13.


(1995), Vol. 43, No. 5 / no 5

to change. Innovative new insurance product ideas began to emerge acrossNorth America in the early 1970s. This trend intensified throughout thedecade, and precipitated a revolution in product design.31 Preferrednon-smoker mortality rates were introduced, thereby substantially loweringpremiums for non-smokers and increasing premiums for smokers. A newmoney concept was developed, whereby the returns credited to the policyreserve were based on the yields available from the current investment ofpremium revenues. Previously, amounts credited to policy reserves werebased on the company’s portfolio average rates of return. Because new moneyrates could not be guaranteed for the duration of the contract, policies be-came variable or adjustable. Depending on current investment returns, thepremiums and/or the amount of the benefits under the policy were adjusted.Companies also began offering an enhanced dividend option on their par-ticipating life insurance contracts. This option involved using the dividendsto buy portions of one-year term coverage and paid-up additions. This ef-fectively transformed the participating policy into a new money contract.

Deregulation of Reserve StandardsBefore 1978, federal insurance legislation required that the superintend-ent of insurance prescribe the mortality and interest rate assumptions tobe used by insurers in calculating their policy reserves. Typically, thesewere based on the Commissioners 1958 Standard Ordinary Mortality Tableand an interest rate of between 3 and 4 percent—very conservativeassumptions.

In 1978, the legislation was amended to shift the responsibility ofestablishing adequate policy reserves, including the underlying mortalityand interest rate assumptions, to a valuation actuary appointed by thedirectors of the insurance company. The determination of policy reservesthus became much more flexible, and a great deal of reliance was placedon the professional judgment of the valuation actuary.

The deregulation of reserves in 1978 paved the way for much of theproduct innovation over the next 15 years. In addition, as the competitivepressures escalated both between the insurance industry and other finan-cial institutions and within the industry among companies competing formarket share, policy reserves became considerably less conservative after1978. This has resulted in significantly increased price competition in thelife insurance marketplace.

Tax SystemThe 1969 tax reform for the insurance industry turned out to be a trial runfor a massive reform of the entire income tax system, which was launched

31 For a more complete discussion of life insurance product developments in the late1970s, see John A. Bowden, “The Role of Life Insurance Products in Estate PlanningFollowing the Federal Budgets of November 1981 and June 1982,” in Report of Proceed-ings of the Thirty-Fourth Tax Conference, 1982 Conference Report (Toronto: CanadianTax Foundation, 1983), 833-43.


(1995), Vol. 43, No. 5 / no 5

with the release of a white paper in November 1969.32 The white papersparked widespread public debate and exhaustive hearings before com-mittees of both the House of Commons and the Senate.33 This processculminated in 1971 with the introduction of Bill C-259, which contained750 pages of detailed amendments to the Income Tax Act—the largestincome tax bill ever to be dealt with by the Canadian parliament.

Reforms included the introduction of the tax on capital gains, a funda-mental restructuring of the taxation of corporations and their shareholders,and modifications of resource incentives. Having just gone through thetrauma of becoming subject to income tax for the first time, the lifeinsurance industry was left relatively untouched by the 1971 tax reforms.

In 1974, the government introduced a special $1,000 tax exemption forinterest income earned by individuals in recognition of the adverse im-pact of inflation on savings.34 The exemption was expanded in 1975 toinclude dividend income and in 1977 to include capital gains. With theIIT imposed at the corporate level, there was no easy way to extend thebenefits of the exemption to individual savings through life insurance.This problem was the catalyst that precipitated major changes to the taxa-tion of life insurance in 1978.

1978 Policy Holder ChangesThe March 1977 budget proposed two significant changes relating to thetaxation of investment income earned inside life insurance policies. First,the IIT (imposed under part XII of the Act) was to be repealed. Explainingthe proposed repeal, the minister of finance said:

[W]hen the government introduced the $1,000 exemption for interest anddividend income, the balance between competing forms of savings mayhave been upset. Therefore, the Part XII tax will be repealed and the invest-ment income on life insurance policies and annuities will be allowed toaccumulate tax-free for the benefit of the policyholder.35

The second change, intended as the quid pro quo for the IIT, was to taxthe investment gain implicit in a life insurance policy upon the death ofthe insured in the same manner as it was taxed upon the surrender ormaturity of the policy.

The reaction of the life insurance industry to this second proposal wasswift and violent. The proposal, variously dubbed the “tax on death” andthe “widows’ and orphans’ tax,” was quickly withdrawn “pending further

32 E.J. Benson, Proposals for Tax Reform (Ottawa: Department of Finance, 1969).33 See Canada, House of Commons, Eighteenth Report of the Standing Committee on

Finance, Trade and Economic Affairs Respecting the White Paper on Tax Reform (Ottawa:Queen’s Printer, 1970) and Canada, Senate Standing Committee on Banking, Trade andCommerce, Report on the White Paper Proposals for Tax Reform Presented to the Senateof Canada (Ottawa: Queen’s Printer, 1970).

34 SC 1974-75-76, c. 26, section 70, effective for the 1974 and subsequent taxationyears.

35 Canada, Department of Finance, 1977 Budget, Budget Document, March 31, 1977, 43.


(1995), Vol. 43, No. 5 / no 5

study.”36 Surprisingly, the government proceeded with the repeal of theIIT. As a result, after 1977 the investment income accumulated for thebenefit of a policy holder was subject to tax only upon a disposition,surrender, or maturity of the policy other than on death.

Another amendment arising from the 1977 budget included amountsreceived from a policy loan made after March 31, 1978 as proceeds ofdisposition of an interest in the policy.37

The 1969 amendments did not deal specifically with policy loans. Itwas, and still is, an open question whether a policy loan is a loan in thestrict legal sense. In some cases the arrangement may be a true loan madeby the insurance company from its general funds and secured by thepolicy. In other cases, it may be merely an advance on the owner’s inter-est in the policy, which the owner is under no obligation to repay.

If a policy loan is not treated as a disposition, the owner effectivelycan defer the payment of tax until the policy is surrendered or matures. Ifthe policy is left in force until death, tax is avoided altogether. The 1977amendment was intended to block this perceived abuse.

Changes to the segregated fund rules were also made in 1977. Theoriginal provisions introduced in 1969 proved not to achieve the objec-tive of taxing such funds in the same way as if the funds were invested inan unincorporated mutual fund. The 1978 amendments deem a segregatedfund of a life insurer to be a separate inter vivos trust. The annual incomeof the fund is deemed to be distributed to the policy holder as the deemedbeneficiary of the trust.38 These changes finally put segregated funds onan even footing with mutual fund trusts.

1978 Company ChangesBy 1977, eight years after the introduction of income tax on life insur-ance companies, many cracks and anomalies had developed in the system.In an attempt to shore up the sagging structure, major changes were intro-duced, effective in 1978. In a memorandum to the industry in February1978, the Department of Finance stated: “The reserves available to lifeinsurers under the income tax law in force to the end of 1977 . . . wereclearly excessive.”39 The main reason for this excessive level of policyreserves was the use of the net level premium method of calculation. Underthis method, a constant proportion of each premium is set aside in thereserve. This does not recognize that the early premiums are used by theinsurer to fund heavy front-end distribution and administrative costs. Sincesuch policy acquisition costs are deductible for tax purposes as incurred,

36 Canada, House of Commons, Debates, October 20, 1977, 101.37 SC 1977-78, c. 1, section 74(5), amending subparagraph 148(9)(c)(ii) of the Act.38 Ibid., section 74(2), amending subsection 148(3) of the Act and section 23(1), re-

pealing paragraph 56(1)(k) of the Act.39 Department of Finance memorandum, “Transitional Rule for Policy Reserves of Life

Insurers,” February 1978, 1.


(1995), Vol. 43, No. 5 / no 5

their deduction plus the deduction for a net level premium reserve resultedin a significant tax loss in the year the policy was issued. A constantlygrowing insurance business using the net level premium reserve methodtends to produce continuing tax losses and a growing tax deferral.

The 1978 amendments replaced the net level premium method with thefull preliminary term method for calculating policy reserves. Under the fullpreliminary term method, no reserve is permitted in the year the policy isissued. This tends to balance the deduction for acquisition costs with thepremium revenues received during the first year after a policy is issued.Various other amendments were also made to the MTAR regulations,including some modification to the underlying interest and mortalityassumptions.

The rules for the allocation of a life insurance company’s income be-tween Canadian and foreign operations were also substantially modifiedin 1978. Significant shortcomings had been discovered in these provi-sions, which permitted companies to allocate a disproportionately largeamount of income offshore, avoiding the incidence of Canadian tax.40

THE 1980SIndustry EnvironmentEconomic ConditionsAnnual inflation rates continued to rise in the early 1980s and againreached double digits. The yield on long-term Canada bonds also sky-rocketed to over 15 percent in 1981. However, by 1983 the worst recessionsince the early 1930s had taken hold and the rate of inflation fell dramati-cally, hovering between 4 and 5 percent for the rest of the decade. Interestrates also declined, although somewhat more slowly; the yield on long-termCanada bonds settled at just under 10 percent by 1990.

Interest-Sensitive ProductsThe revolution in life insurance product design was in full swing in 1980.The new money concept, which shifted some of the investment rewardsand risks back to the policy holder, was a major breakthrough in policydesign. A proliferation of interest-sensitive products hit the market in theearly 1980s, capitalizing on the high interest rates then available and theexpectation that such high rates might continue indefinitely.

The new money concept, first introduced in the Canadian market in themid-1970s quickly evolved into the universal life style of product de-sign.41 Today’s universal life products are characterized by:

1) the unbundling of the protection and savings components of the policy;

40 For a detailed discussion of the 1978 amendments, see Ronald C. Knechtel, “Taxa-tion of the Life Insurance Industry: The 1978 Tax Reform” (1980), vol. 28, no. 1 CanadianTax Journal 9-31.

41 For a discussion of the universal life concept, see, for example, Strain, supra foot-note 5; and G.R. Dinney, (1982), vol. 4, no. 21 Canadian Journal of Life Insurance 9-12.


(1995), Vol. 43, No. 5 / no 5

2) a great deal of flexibility in the choice of coverage patterns, pre-mium deposit schedules, and investment options; and

3) contractual guarantees related to expense loadings, mortality riskcharges, investment yields, and the tax status of the policy.

The hallmark of the universal life policy is flexibility. This flexibleand unbundled approach coupled with the enormous power of personalcomputers makes it possible to custom-craft life insurance applicationsfor particular business and personal financial and estate plans.

Lapse-Supported ProductsBy the mid-1980s, the complexion of the life insurance industry wasradically different from what it had been 15 years earlier. A large numberof small to medium-sized companies had entered the market and werecompeting aggressively for market share. Growth was seen to be the keynot only to prosperity, but to survival in the long term. Price competitionbecame intense, and companies were forced to cut margins and be muchmore aggressive in setting their pricing assumptions for new products.

This was the environment that spawned the lapse-supported products.The most basic lapse-supported product is the term-to-100 policy. How-ever, the lapse support feature also began to creep into other productdesigns in the middle to late 1980s. Products with early surrender chargesor low early cash values (some with the promise of bonus interest later)are examples of other forms of lapse-supported policies.

Illustration WarsWith the advent of adjustable and interest-sensitive products came illus-tration warfare. Computer software systems were developed by companiesselling these products so that their performance could be illustrated undera variety of assumptions as to future interest rates, mortality experience,and other factors that may affect performance over the long term.

The sales and marketing practices of many companies and life insur-ance agents were tending to focus mainly on the illustrations of potentialfuture performance under somewhat rosy assumptions of long-term inter-est rates and mortality experience. The actuarial profession has attemptedto focus attention on the dangers of over-reliance on illustrations and ofinadequate disclosure to consumers of the non-guaranteed nature of someillustrated policy features and values.

To increase the consumer accountability of their products, companiesare increasingly providing contractual guarantees of mortality costs andexpenses for the duration of the policy. In addition, the investment yieldon funds accumulated for the benefit of the policy holder may be linkedto an independent index.

Tax SystemThe 1978 tax amendments proved highly unsatisfactory to the govern-ment. The repeal of the IIT without a companion provision to tax the


(1995), Vol. 43, No. 5 / no 5

accumulated cash values in a policy on death resulted in a significant lossof tax revenue. The government also felt that the tax environment for lifeinsurance created a substantial bias in favour of life insurance comparedto other forms of savings and investment. The aggressive marketing ofnew money policies and illustrations of single premium life insurance anddeferred annuity products extolling their tax deferral advantages onlyfuelled the fires.

1981 BudgetFinance Minister Allan MacEachen’s budget of November 1981 raised astorm of protest unparalleled in Canadian history. Many of the proposalscame as a complete surprise to the business and professional communi-ties. But it was the retroactive application of many of the provisions thatcreated so much furor. The government was clearly taken aback by themassive reaction and began backtracking almost immediately. A series ofconcessions were made before enabling legislation was finally given royalassent in March 1983.

The life insurance industry was hit particularly hard by the 1981 budget.The provisions permitting an individual to spread the tax payable onspecified types of income over a period of years, through the purchase ofan income averaging annuity contract (IAAC), were repealed.

Three significant changes to the taxation of investment income accu-mulated within life insurance policies were also proposed.42 First, forpolicies issued after November 12, 1981, it was proposed that individualpolicy holders would be subject to tax every three years on the accruedinvestment income in their policies. Corporate policy holders would betaxed annually. Accrual taxation was also to apply to all debt instrumentsand annuities. Second, the 1977 proposal to tax the accumulated invest-ment income in a life insurance policy on death was resurrected for policiesissued after November 12, 1981. In bringing back this proposal, the gov-ernment evidently felt that it would be accepted as merely an extension ofthe first proposal to tax the accumulating income on an accrual basis.Third, a change was proposed to the taxation of life insurance policies inforce on budget day. For dispositions after budget day, the ACB of a lifeinsurance policy was to exclude that portion of the premiums not reason-ably related to the savings element of the policy. This was to beaccomplished by deducting the net cost of pure insurance from the ACBeach year, potentially resulting in a substantial increase in the taxableincome on the disposition of the policy.

The final amendments passed by Parliament in March 1983 are sum-marized below.

42 See Canada, Department of Finance, 1981 Budget, Budget Papers, SupplementaryInformation and Notices of Ways and Means Motions on the Budget, November 12, 1981.


(1995), Vol. 43, No. 5 / no 5

Accrual RulesIndividual policy holders were required to report accrued income at leastevery three years on all life insurance policies acquired after December 1,1982, with the exception of exempt policies and grandfathered policies.43

In 1990, the rules were changed to require annual accrual for policiesacquired by individuals after 1989. Corporations owning policies subjectto accrual have been required to report on an annual basis since 1982.The income inclusion arising on the death of the insured under anon-exempt policy issued after December 1, 1982 equals the investmentincome earned between the last accrual date and the date of death.44

Accrued income on a life insurance policy is measured as the differ-ence between the policy’s accumulating fund and its ACB. The accumu-lating fund is generally the MTAR allowed as a deduction for corporateincome tax purposes. The method of accrual taxation on annuities is simi-lar to that for life insurance policies. Accrual income was eligible for the$1,000 investment income deduction.

Complex grandfathering provisions were introduced to exclude fromthe application of the accrual rules most life insurance policies and annu-ity contracts acquired before December 2, 1982. Unless a prescribedpremium is paid and a prescribed increase in the amount of the deathbenefit of the policy occurs, a life insurance policy acquired before De-cember 2, 1982 is not subject to the accrual rules.45 These extremelycomplicated rules were required mainly because of the advent of theadjustable and universal life style products, which permitted a great dealof flexibility to alter premium payments and modify benefit levels afterpolicies were issued.

Annuity contracts acquired before December 2, 1982 were also gener-ally not subject to the new accrual rules. However, the accrual rules doapply to deferred annuity contracts under which payments had not com-menced before December 2, 1982. For such contracts, there was a delayin the application of the accrual rules until 1987.

Exempt PoliciesThe life insurance industry was adamantly opposed to the taxation of theinside build-up of investment income within a life insurance policy. Afterintensive and exhaustive consultations (negotiations) between the indus-try and the government, a compromise solution was reached to create anexemption from the accrual rules for policies that provide significantamounts of insurance protection relative to the investment accumulation.46

43 SC 1980-81-82-83, c. 140, section 5, adding section 12.2 to the Act.44 Ibid., section 102, amending paragraph 148(2)(b) of the Act.45 Ibid., section 5, adding former subsection 12.2(1)(a) and regulation 309, added by

SOR/83-865 (1983), vol. 117, no. 23 Canada Gazette Part II 4179-92.46 See regulations 306 and 307, added by SOR/83-865, supra footnote 45.


(1995), Vol. 43, No. 5 / no 5

The test to determine whether a policy qualifies for exemption is ap-plied by comparing the accumulating fund (savings component) of theactual policy at each anniversary date with the accumulating fund for ahypothetical “exemption test policy” (ETP) that is deemed to be issued atthe same time the real policy is issued. A policy remains exempt, pro-vided that its accumulating fund does not exceed the accumulating fundof the exemption test policy both (1) at the time the test is applied, and(2) assuming that the terms and conditions of the policy do not change,on a prospective basis at each anniversary date thereafter, generally untilthe life insured attains age 85.

If a policy fails the exemption test at any anniversary date, it losesexempt status forever. However, a 60-day grace period is permitted tobring the policy back onside. If an exempt policy becomes non-exempt,the excess of the accumulating fund over the ACB of the policy holder’sinterest at that time is taxed as ordinary income.

The ETP represents a policy that endows at age 85 and is paid up after20 years. The choice of this model for the protection-oriented policy isarbitrary: it reflects the deal negotiated between the industry and thegovernment in 1983. It was estimated that about 85 percent of policies inforce in 1983 qualified under the exempt test.

Life Insurance Capital Dividend AccountThe industry and the professional community were surprised by yet an-other proposal significantly affecting life insurance that was contained ina press release on June 28, 1982. The minister of finance announced that

corporations will continue to receive life insurance death benefits tax free.However, for policies purchased after June 28, 1982 these amounts may nolonger be paid out tax-free to shareholders through the use of the capitaldividend account.47

The Department of Finance expressed concerns about the potential of taxdeferral through the use of corporate-owned life insurance proceeds toredeem shares of deceased shareholders.48

This proposal was also substantially modified before being implementedin 1983. To address the concerns about undue tax deferral arising frominsurance-financed share redemptions on death, but to recognize thattax-free insurance proceeds received by a private corporation should stillbe available to shareholders free of tax, a special life insurance capitaldividend account (LICDA) was created.

47 Office of the Honourable Allan J. MacEachen, deputy prime minister and minister offinance, Release, no. 82-71, June 28, 1982.

48 For a discussion of the tax consequences of the use of life insurance proceeds toredeem shares see, William J. Strain, “Life-Insured Share Redemption Provides Advan-tages Over Outright Buyback” (September 1993), 5 Taxation of Executive Compensationand Retirement 811-14.


(1995), Vol. 43, No. 5 / no 5

Tax-free dividends out of the LICDA could still be paid to sharehold-ers. However, a dividend out of the LICDA reduced the ACB of shares onwhich it was paid, but only where the shares had been acquired by anestate, heirs, or beneficiaries as a consequence of the death of the share-holder and the dividend could be considered to have been paid on accountor in lieu of proceeds for the disposition of the shares.49

Two years later, at the same time as the $500,000 capital gains exemp-tion was introduced, the LICDA rules were repealed. Although noexplanation was given for the repeal, the provisions were difficult toadminister, and the new exemption may have made the concern about thepotential tax deferral on death seem redundant.

Prescribed Annuity ContractsAn exemption from the accrual rules was also provided for prescribedannuity contracts (PACs). PACs are defined in the regulations as annuitiesunder which payments have commenced and which meet certain condi-tions regarding the type of holder and the pattern of the payment stream.50

The rules for the taxation of annuities originally introduced in 1945have been preserved for PACs. The calculation results in a fixed percent-age of each annuity payment being treated as a return of capital. Thepurpose of the PAC rules is presumably to make it easier for individualannuitants to plan their financial affairs, knowing that the taxable portionof each annuity payment remains the same throughout the term of theannuity.

The conditions for qualification as a PAC were quite restrictive whenoriginally introduced in 1983. For example, the holder of a PAC had to bean individual who was at least 60 years of age or totally and permanentlydisabled. The qualification criteria were softened somewhat effective fromJanuary 1, 1987. An individual of any age (but not a corporation or atrust) may now acquire a PAC. Payments under the contract must be equaland made at least annually. The annuity payments can be for a fixed termor for the life of the owner (or until the later of the death of the ownerand his or her surviving spouse or siblings). The guaranteed or fixed termof the payments cannot extend beyond the 91st birthday of the annuitant(or the youngest beneficiary under the contract). PACs may be issued onlyby a financial institution or a registered charity. Loans may not be madeunder the contracts, and the contracts may not generally be surrenderedor disposed of except on the owner’s death.

49 SC 1980-81-82-83, c. 140, section 22, amending former paragraph 53(2)(r) of theAct, and section 54, amending former paragraph 89(1)(b.2) of the Act.

50 Ibid., section 5, adding subsection 12.2(1) to the Act, section 26, amending para-graph 56(1)(d) of the Act, and section 28, amending paragraph 60(a) of the Act, andregulations 300 and 304, as amended by SOR/83-865, supra footnote 45.


(1995), Vol. 43, No. 5 / no 5

1987 Tax ReformAfter the election of the Conservative government in 1984, Finance Min-ister Michael Wilson placed tax reform high on the government’s agendafor economic renewal. The 1987 white paper on tax reform was some-what anti-climactic, considering all the advance publicity that it hadreceived. Unlike the massive reform of 1972, the proposals did not funda-mentally alter Canada’s tax structure.51

Throughout the 1970s and 1980s the tax system had become riddledwith special preferences or loopholes, resulting in a narrow tax base andconsequently high statutory tax rates. The major thrust of the 1987 taxreform was to broaden the base by substantially cutting back on tax in-centives and reducing both personal and corporate tax rates.

Studies conducted by the Department of Finance in the course of the 1987tax reform process had shown that current federal corporate taxes payable byfinancial institutions were running, on average, at about 14.5 percent of re-ported financial statement income, the lowest of all industry sectors. Incomparison, the highest average rate was for the wholesale trade at 24.5 per-cent, and the average rate across all industry sectors was 18.7 percent.52

Major tax changes affecting the life insurance industry were intro-duced in 1988 to broaden the tax base in an attempt to even out the taxburden across industry sectors. The following is a summary of these pro-visions, which were generally effective January 1, 1988.

1) The MTARs for life insurance policies were reduced by replacingthe full preliminary term method of calculation with the one and one-halfyear preliminary term method. The result was that no actuarial reservewas allowed as a tax deduction during the first 18 months after the issueof a policy. This change reflected the belief that agent commissions andother deductible expenses of issuing a policy generally exceeded the pre-miums taken into income in the first year.53

2) The life insurance policy dividend reserve was limited to the amountof policy dividends actually paid or accrued in the taxation year. Thischange essentially cut policy dividend reserves in half.54

3) The rules for allocating investment income between Canadian and for-eign operations were substantially modified. The old rules had allowedcompanies to designate assets with low yields as Canadian source assets. Theamendments were intended to increase investment income subject to Cana-dian tax to reflect the average rate of return on all Canadian assets held.55

51 See Canada, Department of Finance, Tax Reform 1987: Income Tax Reform (Ottawa:the department, June 18, 1987).

52 Ibid., at 14, chart 2.3.53 See regulation 1401, as amended by SOR/90-661 (1990), vol. 124, no. 21 Canada

Gazette Part II 4224-54.54 SC 1988, c. 55, section 125, amending paragraph 138(3)(a)(iv) of the Act.55 Ibid., amending subsection 138(9) of the Act, and regulation 2411, added by SOR/90-661,

supra footnote 53.


(1995), Vol. 43, No. 5 / no 5

4) A large corporations tax (LCT) was introduced at a rate of 0.175percent (increased to 0.2 percent in 1991) on capital in excess of $10million.56

5) The IIT was reintroduced in 1988.

Investment Income TaxThe $1,000 investment income deduction was eliminated in the 1987 taxreform amendments. This prompted the government once again to exam-ine the question whether the investment income element incidental to alife insurance contract should be taxed and, if so, how. In 1987, thisconcern was focused primarily on exempt life insurance policies becauseunregistered annuities and non-exempt policies were already subject tothe accrual rules.

Rather than attempt to tax accumulating income in the hands of theexempt policy holder, the government reintroduced the old IIT in a modi-fied form. The explanation given in the white paper was as follows:

The current exemption from tax of investment income built up in life insur-ance policy reserves creates a bias in favour of insurance. The new tax willensure that the investment income accumulating over the years in the policyreserves of life insurance companies bears a reasonable level of tax.57

The resurrection of the IIT again sparked an intense debate betweenthe government and the life insurance industry. In addition to fundamen-tal disagreements over the need for the tax, there were substantialdifferences of opinion as to the design of the system and the estimates ofthe revenue that would be raised. The House of Commons Finance Com-mittee observed that “most policyholders who purchase exempt policiesare not in a net gain position until between 8 and 13 years after thepolicies are issued in the case of a whole-life policy.”58 The committeerecommended that the government not proceed with the introduction ofthe IIT. Instead, the committee recommended a new form of minimumcorporate tax for banks, trust companies, and life insurance companies. Inthe end, the IIT was implemented, but in a substantially modified form.The base for the application of the IIT was changed again and greatlysimplified for 1990 and subsequent years.

The version of the tax introduced in 1988 was a subtractive approach,starting with the entire amount of Canadian investment income and sub-tracting elements that should not be taxed (for example, the portion ofinvestment income already taxed under part I, investment income relatingto annuities and non-exempt policies that is subject to the accrual rules,and income on registered retirement plan arrangements).

56 SC 1990, c. 39, section 48, adding part I.3 to the Act.57 Supra footnote 51, at 128.58 Canada, House of Commons, Standing Committee on Finance and Economic Affairs,

Report on the White Paper on Tax Reform (Stage 1) (Ottawa: Queen’s Printer, November1987), 107.


(1995), Vol. 43, No. 5 / no 5

A simple “additive” basis applies for the purposes of calculating thetax base after 1989. This approach starts with the MTAR, essentially forexempt life insurance policies. A net interest rate, linked to the yield onlong-term Canada bonds and reduced by a factor (generally 45 percent) tonet out investment expenses and the insurer’s spread, is then applied tothe amount of the reserves. A deduction is allowed for taxable gainsreported to policy holders on the disposition of exempt policies.59

The on-again, off-again history and the machinations involved in at-tempting to devise an appropriate base for the IIT only serve to demonstratethat splitting the investment and insurance elements of an ordinary lifeinsurance policy is an artificial exercise.

THE 1990SIndustry EnvironmentEconomic ConditionsThe Canadian economy again plunged into a deep recession in the early1990s. The bottom fell out of the real estate market, causing a devastatingimpact on life insurance companies that were heavily invested in residen-tial and commercial mortgages. Interest rates fell dramatically. Short-termyields on government bonds fell from almost 11 percent at the beginningof 1990 to under 5 percent in 1993 and early 1994. The yield on long-termCanada bonds also fell from 10 percent at the beginning of 1990 to a lowof just under 7 percent in January 1994. Inflation was all but eradicatedin the early 1990s: the average annual inflation rate plummeted from 5percent in 1989 to 0.2 percent in 1994.

Never in Canadian history had a policy holder lost money as a result ofthe failure of a Canadian life insurance company. The 1990s have seenthe collapse of three companies, the Sovereign Life Insurance Company,Les Coopérants, and Confederation Life Insurance Company. The failureof Confederation Life, one of Canada’s oldest and largest insurance com-panies, shook the life insurance industry to its very foundation.

Now that the dust has settled, at least partially, it seems clear that thefailure of Confederation Life was not indicative of widespread weaknessacross the industry. Most of the large Canadian life insurance companieshave reported excellent financial results for 1994. The major Canadiancompanies still enjoy claims-paying ratings that are equal to or betterthan the ratings of the best Canadian banks.60

Product EvolutionThe sharply lower interest rates that have prevailed over the last fewyears have served as a wake-up call for both the buyers and the sellers of

59 SC 1988, c. 55, section 160, adding part XII.3 to the Act.60 For a discussion of the current financial strength of the Canadian life insurance

insustry, see John Sherrington, “Access to Capital Markets,” in The Battle for the Cana-dian Insurance Industry (Toronto: Insight Press, May 1995), 99-111.


(1995), Vol. 43, No. 5 / no 5

non-guaranteed insurance policies. A policy holder, expecting to purchasea paid-up policy in as little as five years on the basis of an illustrationassuming double-digit investment returns, is now facing the prospect ofsubstantially higher premium deposits or payments over a much longerterm to maintain the policy in force.

The low-interest environment has highlighted the limitations of thepolicy illustration as a sales and marketing tool. It has also reinforced theneed for full disclosure of the investment risks assumed by the policyholder when buying an interest-sensitive product.

In response to a growing awareness of the impact of investment returnson the performance of a life insurance policy, insurance companies arenow offering policy holders a variety of investment options. The choicesmay be based on the company’s own investment performance or may belinked to money market rates for 30-day, 1-year, 5-year or longer terms.The yield may also be linked to equity indices such as the TSE 300 or theS & P 500. Some companies offer investment yields linked to the per-formance of specified mutual funds.

Several product innovations have been introduced as a direct result ofchanges in the tax legislation. For example, some companies modifiedtheir policies after the reintroduction of the IIT to provide a credit to thepolicy holder on withdrawals or the surrender of the policy in recognitionof the corresponding reduction in the company’s tax liability.

The term-to-100 product had gained a significant market share by theearly 1990s, particularly with older buyers. Because of the nature of theguaranteed term-to-100 policy, the assumptions of mortality, lapse rate,and investment yields over the long term are critical in designing a prof-itable product for the company.

It has recently become painfully apparent to many companies that theassumptions of both interest and lapse rates established for their term-to-100 products in the 1980s were much too aggressive.61 A major factorcontributing to the lower than expected lapse experience has been theback-to-back or insured annuity strategy.

The insured annuity strategy involves the coupling of an immediatelife-only annuity with a term-to-100 insurance policy. An individual, usu-ally over 60 years of age, purchases a prescribed annuity payable for lifewithout any guarantee period. The payments from the annuity are used tofund the premiums for a term-to-100 life insurance policy providing a deathbenefit generally equal to the purchase price of the annuity. The net effect isthat the capital sum is preserved on death. Because of the low cost of theterm-to-100 policy and the favourable tax treatment of the prescribed annu-ity, the policy holder could enjoy a much greater after-tax income thanwould be earned by simply investing the capital in fixed-income securities.

61 For a discussion of the relationship between the pricing of insurance products andthe long-term solvency of the insurers, see Lloyd Steinke, “Pricing and Solvency” (May/June 1993), CALU Report (Conference for Advanced Life Underwriting).


(1995), Vol. 43, No. 5 / no 5

Recognizing that historical data on lapse rates are not reliable for term-to-100 pricing purposes and that the long-term interest rate assumptionswere far too aggressive, many companies have withdrawn their term-to-100policies from the market; those that remain have increased premiumsconsiderably. However, the term-to-100 concept has recently also becomeembedded in many universal life products.

The most recent versions of many universal life products have incor-porated a level cost of insurance approach. Mortality costs charged againstthe policy’s accumulating fund are switched from a YRT basis to a levelbasis to age 100 which is often fully guaranteed. This newer mortalitycost structure is considerably less unbundled than the YRT structure. Thepre-funding of future mortality costs, implicit in the level cost of insur-ance, is not reflected in the CSV of the policy. Policy holders who surrendera level mortality cost product generally forfeit all the mortality costs thathave been pre-funded. These products are therefore lapse-supported inmuch the same way as the stripped-down term-to-100 product.

Common Standards for Actuarial ReservesBeginning in 1991, common standards for the valuation of actuarial li-abilities (reserves) of life insurance enterprises were adopted by theCanadian Institute of Chartered Accountants (CICA), the Canadian Insti-tute of Actuaries (CIA), and the Office of the Superintendent of FinancialInstitutions (OSFI).62 These standards, which specify the policy premiummethod (PPM) for the valuation of policy liabilities, were developed ex-pressly for use in the valuation of insurance company liabilities inaccordance with generally accepted accounting principles.63

Under the PPM, the actuarial liabilities are based on the best estimatesof all the relevant underlying factors, plus a provision for adverse devia-tion (PAD).64 All future policy benefits and expenses are provided for inthe actuarial liabilities, offset by the recognition of the full amount ofexpected future premiums to be received. Any excess of the present valueof expected future premiums over the present value of expected futurebenefits and expenses (including the PAD) is consequently recognized asincome at the time the policy is issued.

The PAD reflects the degree of risk assumed by the insurance company.The PPM allows only a limited and reasonable provision for adverse de-viation. To the extent that such a provision is not required over the termof the policy, it is taken into income as the company is released from risk.

62 See, for example, Canadian Institute of Chartered Accountants, CICA Handbook(Toronto: CICA) (looseleaf ), section 4210.

63 See Canadian Institute of Actuaries, “Provision for Adverse Deviations for GAAPLife Insurance Company Valuation” (Ottawa, 1990).

64 An unfortunate choice of acronym, virtually certain to raise the suspicions of thetaxation authorities—almost like waving a red flag in front of a bull.


(1995), Vol. 43, No. 5 / no 5

Tax SystemPolicy Holder Exempt TestIn 1991, a small number of life insurance companies, on the basis of avery literal interpretation of the exempt policy regulations, designed anexempt single-premium universal life product providing an increasingdeath benefit, generally over the first 20 years. The consensus within theindustry was that such a product was not in accord with the original spiritand intent of the exempt policy concept.

This single-premium indexed policy design was brought to the atten-tion of the Department of Finance by life insurance industry representa-tives, who urged that the regulations be changed to reflect the originalintent of the exempt policy provisions. The regulations were changed in1994 to clarify the rules for indexed policies. However, all policies issuedbefore the effective date (March 26, 1992) of the new regulations weregrandfathered.65

Company Taxation: Try and Try AgainBy 1992, the federal government had become convinced that the meas-ures introduced in 1988 to increase tax revenues from the life insuranceindustry were not going to work. The 1992 budget indicated that theincome tax system was not generating an appropriate amount of tax rev-enue and that most large multinational life insurers had paid little or notax since the system was first introduced in 1969. The budget went on topropose that revenue-raising measures be developed in consultation withthe industry to ensure that life insurers paid an appropriate amount of taxin both the short term and the long term.

Shortly after the 1992 budget, the government released a discussionpaper proposing radical changes to the tax structure for life insurancecompanies.66 The following were the main areas targeted for reform.

1) The Department of Finance concluded that the system for allocat-ing gross investment revenue between the Canadian and foreign operationsof a multinational company was badly flawed and could not be fixed.Instead, the government proposed a worldwide computation of taxableincome. Canadian tax would then be applied to the Canadian portion ofsuch worldwide taxable income.

2) Reflecting a continuing concern that actuarial reserves were too con-servative, a new approach was proposed to “remove the prudential elementof the liability for tax purposes.” To simplify the computation of income,the proposal was to set the tax reserves at a specified percentage of theliability reported to OSFI and used for financial reporting purposes. The

65 See the amendments to regulation 306, SOR/94-415 (1994), vol. 128, no. 12 CanadaGazette Part II 2431-32.

66 Canada, Department of Finance, untitled paper concerning the tax treatment of lifeinsurance companies, March 12, 1992.


(1995), Vol. 43, No. 5 / no 5

discussion paper recognized that “[c]hanges in this area require careful re-view because of the interaction between solvency requirements and incomemeasurement, and the interaction with the IIT and policyholder rules.”67

3) The government also proposed short-term measures to generate ad-ditional revenue of $55 million in 1992 and $75 million in 1993. Thealternatives put forward included increased capital taxes and a corporateminimum tax of 15 percent based on book income.

The government’s timetable called for implementation of the proposalseffective for the 1993 taxation year. However, the consultation processwith the industry has dragged on to the point where a new set of propos-als was released in January 1995. In the interim, however, a number ofimportant changes have taken place. The capital tax imposed under partVI on large banks and trust and loan companies was extended to life in-surance companies in 1990. Part VI tax is imposed at the rate of 1 percenton the first $100 million of capital employed in Canada in excess of $100million and 1.25 percent on amounts in excess of $200 million. In 1992,an additional tax applicable only to life insurance companies was imposed,increasing the maximum rate to 1.5 percent on capital in excess of $100million. The additional tax also applies, at lower rates, to life insurancecompanies with capital in excess of $10 million.68

In the February 1994 budget, the government introduced provisions re-quiring all financial institutions, including life insurance companies, toreport gains and losses on most of their securities transactions as fully tax-able ordinary income rather than as capital gains. In addition, for thepurposes of determining gains and losses, certain debt and equity securitiesmust now be marked to market—that is, valued at their fair market valueat year-end. Although perhaps simple in concept, the legislation required toimplement these provisions is extremely complex, and runs to more than 40pages of detailed amendments. These rules will both significantly advancethe timing of recognition of income and significantly increase the amountof tax payable under part I for most life insurance companies.69

1995 ProposalsAfter prolonged discussions with the industry, the government released anew discussion paper on proposed changes to the taxation of life insur-ance companies on January 16, 1995.70 The new proposals are as follows:

67 Ibid., at 6.68 SC 1994, c. 21, section 87, adding subsection 190.1(1.1) to the Act and section 91,

adding section 190.16 to the Act.69 For a complete discussion of the provisions, see Hugh G. Chasmar, “Securities Held

by Financial Institutions,” in Report of Proceedings of the Forty-Sixth Tax Conference,1994 Conference Report (Toronto: Canadian Tax Foundation, 1995), 15:1-49; and DavidG. Broadhurst, “New Rules for Investments Held by Financial Institutions,” in The Battlefor the Canadian Insurance Industry, supra footnote 60, at 139-73.

70 Canada, Department of Finance, Discussion Paper on Proposed Changes to Taxationof Life Insurance Companies (Ottawa: the department, January 16, 1995).


(1995), Vol. 43, No. 5 / no 5

1) When originally introduced in 1992, the additional part VI capitaltax on life insurance companies was scheduled to sunset at the end of1995. The discussion paper proposes the repeal of the additional capitaltax as planned.

2) The government has evidently been persuaded to try the currentCanada-only rules for the taxation of multinational life insurance compa-nies one more time. It is proposed that these rules continue to apply withsome modifications.

3) Beginning in 1996, it is proposed that the maximum reserve allow-able as a deduction in computing income for tax purposes be restricted to95 percent of the PPM liabilities reported for regulatory and financialstatement purposes. In other words, a life insurance company would berequired to include in income and pay current tax on an amount equal to5 percent of the annual increase in PPM liabilities for all policies involv-ing life contingencies. Different treatment is proposed for annuities thatare not dependent on survivorship. Reserves for such annuities are to becalculated in the same manner as deposit-taking institutions determinereserves for similar products they offer. These deposit liabilities are gen-erally slightly higher than the corresponding reserves calculated underPPM. It is proposed that the new reserve proposals apply to all policies inforce at the end of the 1995 taxation year. The excess of the maximumreserves allowable under the present rules at the end of 1995 over theamount that would have been deductible at the end of that year under theproposed rules is to be included in the life insurance company’s taxableincome over a 10-year period starting in 1996.

4) The proposed changes to the MTAR rules for corporate purposesalso have implications for policy holder tax purposes. The PPM is notconsidered an appropriate methodology for calculating the accumulatingfund of individual policies. Consequently, the government proposes toretain the current one and one-half year preliminary term method for allpolicy holder taxation purposes, including the accrual rules and exemptpolicy provisions. However, the new reserve rules for annuities not in-volving life contingencies would also be applied for policy holder purposes.Certain aspects of the policy exempt test rules were also targeted fordiscussion, including the age 85 limit, the application of the rules touniversal life policies, and various issues relating to annuities. The gov-ernment is also looking for “ways to simplify the rules while maintainingtheir underlying intent.”71 A reduction in the MTAR would also reduce thebase for IIT purposes. Consequently, adjustments to the interest factorwere proposed to maintain the level of IIT revenue.

The 1995 reserve proposals are very controversial. The discussion pa-per on the proposals states that “[t]he purpose of the 95 percent factor isto reduce, on average, any conservatism built into the net actuarial liabil-ity reported to OSFI.”72 There seems to be a belief that the PAD reflected

71 Ibid., at 14.72 Ibid., at 10.


(1995), Vol. 43, No. 5 / no 5

in the actuarial liabilities of life insurers is a cushion and tends to under-state real economic income.

The industry fundamentally disagrees with this position. Industry rep-resentatives point out that the standard of practice adopted by the CIA in1990 relating to the determination of the PAD was established expresslyfor the purpose of valuing life insurance company liabilities in accord-ance with generally accepted accounting principles. It is argued that thePAD is not an ultraconservative prudential reserve, but recognizes reason-able valuation margins reflecting the assumption of risk by the company,the very essence of the life insurance business.

There is also a great deal of concern over the application of a newregime for tax-deductible reserves to in-force policies, the terms of manyof which are guaranteed. Industry representatives charge that this repre-sents retroactive taxation. They believe that the proposed 10-year transitionperiod is grossly inadequate compared with the average term to maturityof the block of in-force insurance policies on the books of most companies.

The industry response to the government’s 1995 proposals can be sum-marized as follows:

1) Tax reserves (except for annuities without life contingencies) shouldbe set at 100 percent of the PPM reserves plus certain other amounts notrecognized by OSFI in the calculation of the minimum continuing capitaland surplus requirements for life insurers.

2) The current MTAR rules should continue to apply to all in-forcepolicies. They should also continue to apply to both old and new policiesfor IIT and policy holder taxation purposes.

3) The industry position recognized that continuing to apply the cur-rent MTAR method to in-force business will not result in an immediateincrease in tax revenue from the industry. To compensate, it has beensuggested that the additional part VI capital tax continue to apply to lifeinsurance companies for a “few more years” after 1995.

At the time of writing, the consultation process between the Depart-ment of Finance and the life insurance industry representatives continues.Significant changes in the system for the taxation of life insurance arealmost certain to occur. The open questions are when and how extensivethe changes will be.

SUMMARY OF THE CURRENT SYSTEM OF TAXATION OFLIFE INSURANCE POLICY HOLDERSExempt PoliciesThe vast majority of all individual life insurance policies issued in Canadaqualify as exempt policies. The income that is generated from the invest-ment of the accumulating fund for the benefit of the policy holder underan exempt policy is not subject to tax in the policy holder’s hands on anaccrual basis. An amount received as a consequence of the death of aperson whose life is insured under an exempt policy is not considered to


(1995), Vol. 43, No. 5 / no 5

be a disposition of an interest in the policy and therefore is not taxable inthe hands of the recipient. Consequently, the accumulating investmentincome within an exempt policy is not taxed on an accrual basis, nor is ittaxed when received by a beneficiary as part of the death benefit pro-vided by the policy.73

Annual Accrual TaxationThe accumulating income within annuity contracts (including deferredannuities) and non-exempt life insurance policies is taxed on an annualaccrual basis. The annual accrual income is added to the ACB of thepolicy (or the contract) so that it is not subject to double taxation uponthe receipt of annuity payments or upon disposition of the policy. At thetime of death of the life insured under a non-exempt policy (or annuity),the income earned between the last accrual date and the date of death isincluded in taxable income.74

Policy DividendsPolicy dividends received in cash or left on deposit with the insurancecompany are treated as proceeds of disposition of the participating policyholder’s interest in the policy. However, the proceeds are treated first as areduction in ACB, and it is only when the dividends exceed the ACB thatthe excess becomes subject to tax. Dividends that are used to pay premi-ums, buy additional insurance, or reduce a policy loan are treated asinternal policy transactions and are not taken into account in determiningeither the proceeds of disposition or the ACB of the policy.75

Policy DispositionsSubject to specified rollover provisions, where a policy holder disposesof (or is deemed to dispose of) an interest in a life insurance policy(including an exempt policy and an annuity), the excess of the proceedsof disposition over the policy holder’s ACB is taxed as ordinary income.For this purpose, a disposition includes a sale or other transfer of theinterest to another party, a surrender of the policy, a withdrawal from thepolicy, and a loan received from the insurer pursuant to the terms andconditions of the policy. Where an exempt policy ceases to qualify assuch, the policy holder is deemed to dispose of his or her interest forproceeds equal to the accumulating fund of the policy holder’s interest atthat time.76

If a partial withdrawal is made from a policy, the policy holder isconsidered to have disposed of a part interest in the policy. To determine

73 Section 12.2 and regulation 306 of the current Act.74 Section 12.2 and paragraph 148(2)(b) of the current Act.75 Paragraph 148(2)(c) of the current Act.76 See the definitions of “disposition” and “proceeds of disposition” in subsection 148(9)

of the current Act.


(1995), Vol. 43, No. 5 / no 5

the gain from a partial disposition, the ACB of the part interest is calcu-lated as the proportion of the policy holder’s total ACB that the amountwithdrawn bears to the total accumulating fund in respect to the policyholder’s interest immediately before the withdrawal.77 A policy loan, onthe other hand, is included in the policy holder’s income only to theextent that the amount of the loan exceeds the total ACB of the policyholder’s interest in the policy.78

Adjusted Cost BasisIn general terms, the ACB of a policy holder’s interest in a life insurancepolicy is the aggregate of the premiums previously paid less the mortalitycost (the net cost of pure insurance) incurred. Amounts previously in-cluded in the policy holder’s income are added to the ACB of his or herinterest in the policy.79

Flowthrough TreatmentWhere a private corporation is the beneficiary of a life insurance policy,the excess of the proceeds received as a consequence of the death of thelife insured over the ACB of the corporation’s interest in the policy isadded to the capital dividend account. Such amounts are thus availablefor distribution to shareholders as tax-free dividends.80

Similar flowthrough provisions apply where a partnership is the ben-eficiary of a policy. The excess of the proceeds received as a consequenceof the death of the life insured over the ACB of the partnership’s interestin the policy is added to the ACB of the partners’ interests in the partner-ship. This permits the distribution of life insurance proceeds to the partnersas a tax-free capital payment.81

Segregated FundsInvestments in the segregated funds of an insurance company do notqualify for exemption. The holders of segregated fund contracts are treatedas having an interest in a “related segregated fund trust.” The income ofthe trust (interest, dividends, and realized capital gains and losses) isdeemed to be payable each year to the trust beneficiaries (that is, thesegregated fund contract holders) and is taxed in their hands on aflowthrough basis. The gain or loss on disposal of a contract holder’sinterest in a segregated fund is treated as a capital gain or loss.82

77 Subsection 148(4) of the current Act.78 Ibid.79 See the definition of “adjusted cost basis” in subsection 148(9) of the current Act.80 Subparagraph 89(1)(b)(iv) of the current Act.81 Subparagraph 53(1)(c)(iii) of the current Act.82 Section 138.1 of the current Act.


(1995), Vol. 43, No. 5 / no 5

TOMMOROW: GAZING INTO THE CRYSTAL BALL“Turbulent” is perhaps the best word to describe the development ofCanada’s current system for the taxation of life insurance. Major reforminitiatives were launched in 1968, 1977, 1981, 1987, and 1992, and againin 1995. Yet the government is still unhappy about the amount of incometax revenue generated from the life insurance industry. Company officialsdo not share the view that the life insurance industry does not pay its fairshare; they point to over $1 billion in taxes paid in 1992 to all levels ofgovernment, including income, capital, premium, sales, payroll, and realestate taxes. And the debate goes on.

Where will the continuing saga of Canada’s beleaguered attempts tocome up with a fair and equitable system for taxing life insurance lead?Only time will tell. However, on the basis of past history, the followingobservations are offered as to what the future might hold in store.

Policy Holder TaxationIt will be a brave or a foolhardy politician who attempts to impose in-come tax on proceeds received under a life insurance policy on death.The public outcry that arose from past efforts to apply tax to any portionof proceeds payable on death should be a clear message to governmentthat a “widows’ and orphans’ tax” will not be tolerated. The tax-freenature of life insurance proceeds is as ingrained in the public’s perceptionas the tax-free character of gains realized on the sale of an individual’shome.

The savings and protection elements of most permanent life insurancepolicies are so intertwined as to be inseparable for the purposes of taxingthe inside build-up of investment income at the policy holder level. Thisis so even with the unbundled design of universal life policies, particu-larly in recent versions involving the use of level mortality charges.

The accumulating income related to an individual policy may not bereflected in the cash surrender value of that policy at the time it is earned,or perhaps ever. Taxing such income in the hands of the policy holder onan accrual basis may result in currently taxing amounts that the policyholder cannot then receive and may never realize. Moreover, even wherethe accumulating income is reflected in the CSV of the policy, the policyholder would have to forfeit the insurance protection offered by the policyto realize on the cash value in order to pay the tax. It is therefore likelythat the “exempt policy” concept will be retained for life insurance poli-cies that provide a significant degree of pure insurance protection inrelation to the accumulating income within the policy.

In the light of the current spotlight on consumer protection issues inrelation to life insurance, pressure may build to permit a tax-deferredrollover from a policy issued by one company to a policy providing sub-stantially similar terms and conditions offered by another company. Atpresent, the owner of a permanent policy with a significant accumulationelement may effectively be locked in because of the substantial tax that


(1995), Vol. 43, No. 5 / no 5

would be payable if the policy were to be surrendered, even if the pro-ceeds were to be transferred to a similar policy issued by another insurer.

Expanded tax-deferred rollovers might also be appropriate to permit apolicy holder to transfer an interest in a life insurance policy to a corporationin exchange for shares or to a partnership in exchange for an interest in thepartnership.

Investment Income TaxIf the inside build-up of investment income in a permanent life insurancepolicy cannot be taxed on a fair and equitable basis at the policy holderlevel, the IIT will probably become a permanent fixture of Canada’s taxsystem. It seems extremely unlikely that the government will forgo tax onthe investment income accumulating for the benefit of policy holders thatis not currently taxable in the hands of either the policy holder or thecompany. However, the calculation of an appropriate base for the IIT maybecome problematic if the method for determining the MTAR for corpo-rate tax purposes is uncoupled from the method of calculating the basefor IIT purposes.

Perhaps the most troubling issue concerning the IIT has been the selec-tion of an appropriate tax rate. The imposition of a flat 15 percent tax isseen to be inequitable. Many individual policy holders would not be sub-ject to a tax rate as high as 15 percent on their overall income. Otherswho are in higher tax brackets benefit from both a deferral of tax andcomplete exemption if the policy is held until death. However, the alter-native of attempting to tax individual policy holders on the accumulatingincome is likely to create as many, if not more, inequities.

The 15 percent tax rate seems to generate an appropriate level of tax inthe aggregate. According to the government’s last tax expenditure esti-mates, the shortfall in tax revenue as a result of imposing the IIT ratherthan taxing accumulating income at the policy holder level amounted toonly $55 million in 1991.83

Insurance Company TaxationRepeated attempts by the federal government over the years to raise a rea-sonable level of income tax have failed. However, with the 1995 propos-als, the pendulum may have swung too far. Studies conducted for a numberof smaller insurance companies indicate that the impact of the proposalson their earnings and financial position will be severe. The effective taxrate on income reported for statutory purposes and in accordance withgenerally accepted accounting principles for some companies could besubstantially in excess of 50 percent for as long as 25 years. On the basisof these studies, it seems that the government may accept the industry’s rec-ommendation to permit a deduction for 100 percent of PPM reserves.

83 Canada, Department of Finance, Government of Canada—Tax Expenditures (Ottawa:the department, December 1994), 27.


(1995), Vol. 43, No. 5 / no 5

One of the attractions of linking tax reserves to the actuarial valuationof liabilities for regulatory and financial reporting purposes is that itprovides a self-policing mechanism, not only for Revenue Canada butalso for OSFI. In today’s environment, all companies, whether stock ormutual, whether public or private, whether Canadian- or foreign-owned,are under pressure to report earnings and strengthen their balance sheets.Revenue Canada can take comfort from the fact that companies will notbe inclined to report overly conservative actuarial liabilities in order todepress taxable income. OSFI can take comfort from the fact that compa-nies will not be inclined to report understated actuarial liabilities that willincrease the company’s current taxes payable.

It is surprising that the government seems prepared to once again try tofix the Canada-only approach to the taxation of multinational companiesbased on an allocation of gross investment revenues. In 1992, the Depart-ment of Finance identified the basic flaw in this method as the law oflarge numbers: “A slight mismeasurement of the gross investment rev-enue can result in large changes in taxable income.”84 No amount of finetuning will cure this fundamental flaw.

The proposed modifications to the present rules for allocating invest-ment revenues between Canada and foreign operations will probably notprove satisfactory from the government’s perspective. Look for a reintro-duction of a proposal to impose worldwide taxation on multinationalinsurers. This may prove to be much less of a problem in the future if themultinational companies continue the present trend of incorporating theirforeign operations.

The process of financial deregulation continues in Canada. The dis-tinction between the roles of banks, trust companies, securities dealers,and insurance companies becomes more and more blurred. The govern-ment will come under increasing pressure to ensure that the tax system isneutral across the financial services sector. During the rest of the decadethe tax system for life insurance companies will probably shift to morereliance on taxes on income and less reliance on taxes on capital. How-ever, the shift may not be as soon as either the government or the industrywould like.

INTO THE 21ST CENTURYLooking further ahead into the 21st century, it is impossible to predicthow Canada’s tax system may evolve in response to the trends of theaging population, increasing austerity and the downsizing of government,the growing integration of the world economy, and the information revo-lution. To speculate on where the system for the taxation of life insurancemay fit in that context would be pure folly. However, one of the moreimportant issues may well be the need for much greater internationalharmonization. One only has to look at the diversity of approach to the

84 Supra footnote 66, at 1.


(1995), Vol. 43, No. 5 / no 5

taxation of life insurance around the world to realize just how daunting atask international harmonization would be.

The debate over replacing the present progressive income tax systemwith a broadly based flat tax or a consumption- or expenditure-based taxsystem is heating up both in the United States and in Canada. Just howthe taxation of life insurance might fit within such systems is anybody’sguess. All bets are off.

taxation of life insurance - ctf.ca · for the taxation of life insurance in 1968, major...

Documents