Which Part of a Premium Is Deductible When a Contract Is Assigned

Premiums paid for a life insurance contract are not deductible. That is where the Canadian income tax answer begins, and it holds for an individual and for a corporation alike. Income Tax Act paragraph 18(1)(a) allows an outlay only to the extent it was incurred to gain or produce income from a business or property, and paragraph 18(1)(b) denies a payment on account of capital. A premium on a life insurance contract runs into both of those denials at once, and neither of them has an exception written into it for a contract of any particular design.

One provision changes that answer in one situation, and it changes it far less than most readers are told. Where an interest in the contract has been assigned to a lender as collateral for a borrowing, Income Tax Act paragraph 20(1)(e.2) permits the deduction of a computed amount. That amount is the least of three amounts the provision names. This page sets out what the three are, why the third usually governs, and which document an accountant will ask for. It states no figure of any kind, because every figure here belongs to one specific file and to the accountant who owns that file. Nothing written here is tax advice.

Why is a premium on a life insurance contract not deductible?

Because the Income Tax Act denies it twice over. Paragraph 18(1)(a) allows an outlay only to the extent it was incurred to gain or produce income from a business or property, and a premium buys protection against a death. Paragraph 18(1)(b) separately denies a payment on account of capital. The contract is an asset, so the premium is capital.

That general rule reaches everyone who pays a premium, and it does not soften with the size of the contract or with the reason for owning it. A corporation carrying a contract on a shareholder's life pays the premium out of after tax money. An individual carrying a contract for an estate obligation does the same. Neither position produces a deduction on its own, and no design of the contract manufactures one. The premium is paid with money on which tax has already been settled, and the Act treats that as the ordinary case.

The question that follows is where the exception lives, and it lives in one paragraph of the deduction section. Section 20 of the Act lists amounts a taxpayer may deduct despite the denials in section 18. Paragraph 20(1)(e.2) is on that list. Its marginal note names the situation it covers, premiums on life insurance used as collateral, and it covers nothing outside that situation. The wider arrangement in which this question usually arises is set out on the immediate financing arrangement.

What does paragraph 20(1)(e.2) actually permit?

It permits a deduction of the least of three amounts in respect of a life insurance policy, where an interest in that policy is assigned to a restricted financial institution in the course of a borrowing from the institution. The provision excludes an annuity contract and an LIA policy. What it permits is a computed amount and never the premium.

Read the opening words and the shape of the provision is already visible. It does not say that a premium becomes deductible once a lender holds security. It says the least of three amounts, and it then defines all three. Two of them are ceilings on each other, and the third reduces whichever of those two is smaller. A reader who stops at the first of the three has read the most generous line in a provision that carries two more.

The term restricted financial institution is a defined term. The definition is in Income Tax Act s.248(1), and that definition is where the question of whether a particular lender qualifies gets answered. This page prints no list of what falls inside it, because the point is a question of law on the facts of the lender and the loan, answered by counsel reading the definition against the actual documents. Have the accountant confirm it in writing before a deduction is claimed.

What are the three amounts, and why does the least of them govern?

The first is the premiums payable under the contract in respect of the year. The second is the net cost of pure insurance for the year, determined in accordance with the regulations. The third is the portion of the lesser of the first two that can reasonably be considered to relate to the amount owing under the borrowing.

The order in which those sit is the whole of the arithmetic. The first two are compared and the smaller one survives. The survivor is then cut down to the part of it that relates to what is owed. Three amounts go in and one comes out, and the one that comes out is never larger than the smallest amount that entered. That is why the word premium and the word deduction describe two different quantities in this provision.

A reader shown only the first amount has been shown a ceiling with none of the floors beneath it. The provision is drafted so that the deduction follows the cost of the protection actually standing behind the lender's security, and no further. Anyone who quotes a deductible amount without naming all three limbs has quoted an amount the Act does not allow. The arithmetic belongs to the taxpayer's CPA, working from the contract, the loan documents and the insurer's figures.

What is the net cost of pure insurance?

It is a prescribed amount. Income Tax Regulations s.308 sets out how it is computed for the purposes of subparagraph 20(1)(e.2)(ii), and the regulation prescribes more than one computation, because the method turns on when the contract was issued. The insurer applies the prescribed method. No insurer selects the number.

The label describes what the amount approximates, which is the cost of the pure protection element inside the contract for that year. Each computation in the regulation works from a probability of death for the year applied to the difference between the amount payable on death and the value accumulated inside the contract. Both of those inputs move every year, in opposite directions in a contract built to accumulate value quickly. So does the result.

Two consequences follow for anyone reading a proposal. The figure is produced by the insurer under a prescribed method and can be requested in writing. And the figure, once produced, is a ceiling that owes nothing to what anyone would like the deduction to be. An accountant holding the insurer's statement is working from the same amount the Act is working from, and an accountant without it is guessing at a limb of the test.

Why does the net cost of pure insurance rise as the life insured ages?

Because the probability of death for the year rises with age, and that probability is the multiplier in the prescribed computation. Early in the life of a contract the probability sits at its lowest, so the net cost of pure insurance sits at its lowest too. It climbs from there for as long as the contract stays in force.

This is the part that surprises people, because it moves the deduction in the opposite direction from the one they expect. A borrower has the largest loan and the strongest appetite for relief in the early years. Those are precisely the years in which the second of the three amounts is smallest, so the second amount is usually what governs early on. The relief grows later, when the contract is old and the borrower may want it least.

A second movement works against the first. The prescribed computation subtracts the value accumulated inside the contract from the amount payable on death, and in a contract designed to build value quickly that subtraction grows as well. The two movements pull in opposite directions across the life of the arrangement. Which one wins in a given year is a question for the insurer's own figures and the taxpayer's CPA, and it cannot be answered from a description.

How does the amount owing reduce the result again?

The third amount takes whichever of the first two is smaller and keeps only the part of it that can reasonably be considered to relate to what is owed to the institution under the borrowing. Where the loan is smaller than the amount payable on death, only the related part of that smaller amount survives into the deduction.

The statute says only this much. The surviving amount is the portion of the smaller of the first two amounts that can reasonably be considered to relate to the amount owing from time to time during the year. No ratio is prescribed, in the Act or in section 308 of the Income Tax Regulations, and no proportion can be read off a coverage figure. A loan repaid during the year therefore carries less, because the provision looks to the amount owing from time to time and never to a single day's balance. The computation on a given file belongs to the taxpayer's CPA, working from the actual balance history.

Two things follow, and both of them land on the accountant's desk. The proportion has to be computed for each year from the actual balance history, so it moves whenever the loan moves. And an arrangement in which the coverage is large and the borrowing is modest produces a small proportion, however large the premium looks on the illustration. The mechanics of the security itself are set out on the collateral assignment and the lender.

Which conditions have to be met before any of this applies?

Three conditions sit inside the first amount and all have to hold. An interest in the policy is assigned to a restricted financial institution in the course of a borrowing from that institution. The interest payable on the borrowing is deductible, or would be but for certain named provisions. And the institution requires the assignment as collateral.

The third of those is stricter than it sounds. A voluntary assignment offered because it seemed prudent does not satisfy it. The institution has to have required the assignment, and the lending documents are where that requirement either appears or fails to appear. This is a drafting point that costs nothing at the outset and cannot be repaired afterwards, so it belongs in front of counsel while the facility is being documented.

The provision also names what it does not reach. An annuity contract sits outside it, and so does an LIA policy, which is a defined term in the Act aimed at a particular kind of financed insurance arrangement. A given contract and a given loan have to be read against both exclusions, and that reading is a question about documents. It is answered by the taxpayer's own tax advisers before a return is filed.

What happens to this deduction if the interest is not deductible?

It disappears. The second condition requires the interest payable on the borrowing to be deductible, or deductible but for certain named provisions, so a borrowing whose interest fails that test cannot support any deduction under paragraph 20(1)(e.2) either. The two deductions are chained, and the chain runs in one direction.

Interest deductibility has conditions of its own, set out in paragraph 20(1)(c), and the heaviest of them is that the borrowed money has to be used to earn income from a business or property. The taxpayer carries the burden of tracing the money to that use. A loan whose proceeds went somewhere ineligible takes the premium deduction down with it, and nothing about the assignment repairs that outcome.

The working reading is simple to state and easy to lose. Two deductions are in play, they are governed by different paragraphs, and one of them is a condition of the other. A file that has documented the use of the borrowed money carefully has also protected the smaller deduction. A file that has not has lost both of them. The tracing question belongs to the CPA and to counsel, and it is answered from records kept at the time.

Who claims the amount, and on which return?

The taxpayer who is liable for the premiums under the contract and who is the borrower under the facility. Where a corporation owns the contract and borrows, the corporation claims the amount in computing its income for the year. Where an individual owns and borrows, the individual claims it on a personal return.

The provision speaks about one taxpayer throughout. It refers to the premiums payable by the taxpayer, to an interest in the policy assigned in the course of a borrowing from the institution, and to the amount owing by the taxpayer to that institution. A structure that splits ownership from borrowing puts those references in two different hands. The survival of the deduction across that split is a question for the taxpayer's tax advisers on the actual documents.

Two administrative points sit alongside. The deduction is claimed for the year in respect of which the premiums are payable, so the claim belongs in that year's own return and never in a later adjustment made when someone notices. And the supporting figures have to be in the file when the return is prepared, which is why the request to the insurer goes out well ahead of the filing deadline. A year whose figures arrive after the return has gone in is a year of avoidable correspondence.

What does the insurer produce, and who asks for it?

The insurer produces a statement of the net cost of pure insurance for the contract for the year, on request. That statement is the document the accountant needs, because the second of the three amounts cannot be computed from a premium notice or from an illustration. Request that statement in writing for each year in which a deduction is claimed.

Three documents travel together on this file. The insurer's statement of the net cost of pure insurance for the year. The lending documents, showing the balance through the year and the institution's requirement that the contract be assigned. And the assignment itself, recorded on the insurer’s file. An accountant holding all three can compute the amount, and an accountant holding one of them is estimating.

None of this is unusual to request and none of it is quick to rebuild years later. An insurer will supply the statement for a current year readily and may take longer over a run of past years. A lender will supply a balance history on request. The assignment is on file with the insurer already. Building the record while it is easy costs little, and it is the work most often left undone.

What does this change about how such an arrangement is justified?

It removes the justification most often offered for it. An arrangement presented as a way to make a premium deductible has been presented on something the Act does not allow, and the deductible portion that does exist is usually far smaller than the presentation implies. An arrangement that needs that portion to work has been justified by the wrong thing.

The order of the three amounts explains why. The premium is the top of the range, and the net cost of pure insurance sits below it in the very years when a borrower most wants relief. The proportion relating to the amount owing then cuts the survivor again. Each limb is computed from documents that already exist, so the result is knowable in advance for any file, and it is knowable before anything is signed. Nobody has to wait for an assessment to find out what the provision gives.

That leaves a cleaner test for anyone weighing such an arrangement. The insurance has to be wanted for what it does, and the borrowing has to stand up as a borrowing. Take the deduction under paragraph 20(1)(e.2) out of the projection entirely and see whether what remains still holds together. If it does not, the deduction was carrying the case, and no amount of correct computation makes that a sound footing.

Who this suits, and who it does not

This page suits a taxpayer who already holds a permanent contract assigned to a lender, or who is being shown an arrangement in which one would be. It suits a corporate owner whose accountant has asked what the deduction is actually worth. It suits anyone who has been told that a premium becomes deductible and who wants the provision itself.

It applies with less force to a reader with no borrowing and no assignment, because the provision then has nothing to attach to. It applies with less force again where the contract is owned for a protection need alone and no lender holds any interest in it. Those readers still pay a premium that is not deductible, and nothing on this page changes that position.

It does not suit a reader who came for an amount. No proportion is stated here, no rate appears anywhere on this page, and no example is worked, because each of them turns on a contract, a loan balance and a year that this page does not hold. Participating whole life insurance is insurance and it is not an investment. Policy dividends are not guaranteed, no value shown on an illustration is promised, and nothing written here promises any result to any taxpayer.

The order to hold is short. Confirm that the institution meets the definition of a restricted financial institution in Income Tax Act s.248(1), confirm that the lending documents require the assignment, confirm that the interest meets the test in paragraph 20(1)(c), obtain the insurer's statement of the net cost of pure insurance, and have the taxpayer's CPA compute the least of the three amounts for the year. This practice holds an insurance licence, gives no tax advice and no legal advice. Every amount named in that sequence belongs to the accountant who signs the return.