Taxation of Life Insurance
←
→
Transcription du contenu de la page
Si votre navigateur ne rend pas la page correctement, lisez s'il vous plaît le contenu de la page ci-dessous
1506 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE
Taxation of Life Insurance
William J. Strain, FCA*
P RÉCIS
L’élaboration d’un régime fiscal équitable pour les sociétés d’assurance-
vie et les titulaires de polices constitue un défi pour les responsables de
l’élaboration de politiques fiscales partout dans le monde. Le secteur de
l’assurance-vie comporte de nombreuses questions épineuses, y compris
la nature éventuelle à très long terme d’une police d’assurance-vie, si, oui
ou non, du point de vue d’une politique sociale, les gains de mortalité
devraient être imposés, si le revenu tiré du placement des réserves au
titre des polices devrait être imposé et, le cas échéant, s’il doit l’être dans
les mains du titulaire de police ou dans celles de la société d’assurance. Il
existe d’autres complications en raison du caractère multinational du
secteur canadien de l’assurance-vie et du fait que presque la moitié de
l’assurance-vie au Canada est fournie par des sociétés mutuelles
d’assurance sur la vie, lesquelles sont détenues entièrement par les
titulaires de polices. Ces facteurs entre autres ont eu une influence
considérable sur l’évolution du régime canadien d’imposition de
l’assurance-vie.
Avant 1968, les sociétés d’assurance-vie et les titulaires de police
étaient presque exemptés d’impôt. Depuis l’adoption d’une structure
officielle pour l’imposition de l’assurance-vie en 1968, des initiatives
majeures de «réforme» ont été entreprises en 1977, en 1981, en 1987, en
1992 et en 1995. Nombre des propositions contenues dans ces réformes
n’ont pas été mises en place ou ont été adoptées sous une forme
considérablement modifiée après une consultation auprès du secteur de
l’assurance-vie.
Cette chronologie de l’imposition de l’assurance-vie au Canada s’inscrit
dans le contexte du secteur en évolution depuis les dernières décennies
et de la récente révolution dans l’élaboration de produits d’assurance-vie.
D’une part, les changements survenus dans le secteur ont influencé
considérablement l’élaboration des politiques fiscales et, d’autre part, les
initiatives en matière de politiques fiscales ont largement influencé le
secteur et l’élaboration de produits en particulier.
En tenant compte des racines et des tendances passées de
l’élaboration de l’imposition de l’assurance-vie, l’auteur conclut en
présentant certaines observations sur ce que pourrait réserver l’avenir.
* Of PPI Financial Group, Toronto.
1506
(1995), (1995),
Vol. 43,Vol.
No. 43, o 5 5 / no 5
5 / nNo.TAXATION OF LIFE INSURANCE 1507
ABSTRACT
Designing a fair tax system for life insurance companies and policy
holders has long been a challenge for tax policy makers around the
world. There are many difficult issues peculiar to the life insurance
industry, including the very long-term contingent nature of a life
insurance policy, whether or not mortality gains should be taxed from a
social policy perspective, whether the income earned from the
investment of policy reserves should be taxed and, if so, whether it
should be taxed in the hands of the policy holder or the insurance
company. Further complications arise because of the multinational
character of the Canadian life insurance industry and the fact that almost
half of all insurance in force in Canada is provided by mutual life insurers,
which are owned entirely by their policy holders. These and other factors
have had a significant influence on the development of the Canadian
system of taxation of life insurance.
Before 1968, life insurance companies and their policy holders were
virtually exempt from tax. Since the introduction of a full-fledged structure
for the taxation of life insurance in 1968, major “reform” initiatives were
undertaken in 1977, 1981, 1987, 1992, and 1995. Many of these reform
proposals either were not implemented or were introduced in substantially
modified form after consultation with the life insurance industry.
This chronology of life insurance taxation in Canada is set in the
context of the changing industry over the past decades and the recent
revolution in life insurance product design. Changes in the industry have
had a significant influence on the development of tax policy; by the same
token, tax policy initiatives have had a significant influence on the
industry and on product development in particular.
Reflecting on the roots of and past trends in the development of
taxation of life insurance, the author concludes by offering some
observations on what the future might hold in store.
These are interesting times for the life insurance industry in Canada. The
severe recession that began in 1990, triggering the collapse of real estate
markets across North America, has taken its toll on the industry. The
failure of a few life insurance companies over the past few years has
focused attention and sparked widespread debate on solvency, consumer
protection, and regulatory issues.
The deregulation of the financial services sector, begun in the late
1980s, resulted in a tidal wave of restructuring in the banking, trust, and
brokerage industries. The restructuring wave rolls on, and is likely to
engulf the life insurance industry throughout the remainder of the decade
as 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. With
investments of over $170 billion at the end of 1993, the industry is a
(1995), Vol. 43, No. 5 / no 51508 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE 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 on income support and other social programs, people are becoming increas- ingly concerned about their long-term financial security. The demand for new 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 a profound impact on the evolution of the industry and the creation of new products. In this, the 50th anniversary year of the Canadian Tax Founda- tion, it is timely to pause and reflect upon the development of Canada’s system 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 insurance companies as it interrelates with policy holder taxation. This historical review 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 and past 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 direction and extent of possible tax changes that will have a significant influence on the life insurance industry as it moves into the 21st century. TAX POLICY CHALLENGES The very long-term nature of the contractual commitments between the policy holder and the life insurance company creates difficult technical challenges in designing a fair and equitable tax system for life insurance companies and policy holders. A fundamental and highly charged politi- cal question is whether life insurance, which provides for the financial security of a deceased’s dependants or indemnifies financial obligations and losses arising on death, is properly the subject of taxation. The peculiar difficulties of taxing life insurance companies and policy holders have bedevilled tax policy makers around the world for many years. The Canadian experience is no exception. To set the stage for the historical review of the taxation of life insurance, the following section describes the tax policy implications arising from the distinguishing char- acteristics of life insurance. The Long-Term Contingent Nature of Life Insurance A life insurance policy is a contract between a policy holder and an insurance company whereby, in consideration for the payment of speci- 1 Canadian Life and Health Insurance Association, Canadian Life and Health Insurance Facts, 1994 ed. (Toronto: CLHIA, 1994), 5. (1995), Vol. 43, No. 5 / no 5
TAXATION OF LIFE INSURANCE 1509
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 of
a specified contingency, usually related to survival of the person whose
life is insured.2 The policy is a contractual commitment on the part of the
insurer that extends over many years. To put the long-term nature of the
life insurance commitment into perspective, consider that a permanent
policy 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 an
income tax is problematic for any business. To some degree, interperiod
allocations of revenues and expenses are required for all businesses to
properly match revenues with the costs necessarily incurred to earn such
revenues and to reasonably apportion the income earned over the busi-
ness cycle. Nowhere is this challenge more formidable than in the life
insurance industry. The annual determination of profit for a life insurance
business involves a process of estimating expected mortality, investment
returns, and expenses over many years. The very essence of the life insur-
ance business is the indemnification of contingent future liabilities. To
calculate income, it is not only necessary to estimate the absolute amount
of the contingent liability but also to determine when the liability will fall
due so that its present value can be estimated.
Mortality Gains and Losses
Insurance is a business of risk intermediation. Life insurance provides
financial protection against the risk of mortality over a period of time.
The insurance company operates as an intermediary, pooling the risks on
a 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, the
premium, after a margin is deducted for expenses and profit, represents
the amount that is required to pay claims. Over the whole insured popula-
tion, there should not be a net mortality gain or loss. However, individual
policy holders will receive either more or less than they contribute to the
risk pool.
Theoretical tax policy considerations aside, legislators ignore at their
peril 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 rationale
for taxing insurance proceeds received on death is difficult to explain,
particularly at a time when beneficiaries are suffering a tragic sense of
personal 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 Uniform
Life Insurance Act adopted by all common law provinces. The provincial legislation in
Quebec is broadly similar to the insurance law of the common law provinces.
(1995), Vol. 43, No. 5 / no 51510 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE
The co-operative nature or mutuality of the insurance arrangement is
evident from the fact that almost half of the life insurance in force in
Canada at the end of 1993 was provided by mutual life insurance compa-
nies, owned entirely by their policy holders. 3 Both mutual and stock
companies can issue participating and non-participating insurance in
Canada. Premiums for participating insurance are higher than those for
insurance written on a non-participating basis. However, participating
policy holders share in favourable mortality, expense, and investment
experience by way of policy dividends.
Important questions must be addressed by the tax policy makers. For
example:
1) Are mortality gains and losses realized by individual policy holders
properly included in the tax base?
2) Should policy dividends be treated as a return of excess premiums
or as a distribution of the insurance corporation’s after-tax income?
3) What provisions are necessary to ensure that the tax system does
not create a bias between a mutual company, owned by its policy holders,
and a stock company, owned by its shareholders?
Savings Versus Protection
The pure cost of insurance increases exponentially with age. On a YRT basis,
the cost of maintaining permanent life insurance increases dramatically over
time and becomes prohibitive at older ages. As an alternative to ever-
increasing premiums, the insured may choose to pay a level premium to
average 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 that
results in the amounts paid during the early years of the contract exceed-
ing the pure mortality cost for those years. Premiums paid in excess of
the related mortality costs and expenses are accumulated and invested by
the insurance company. This accumulating investment fund represents a
reserve held by the insurer to back the obligations to policy holders. At
the end of 1993, Canadian life insurance companies held reserves of
approximately $25 billion backing individual life insurance policies.4
The reserves affect the pricing and performance of a policy in two
ways. First, in the later years of a policy when the premiums are not
sufficient to cover the mortality cost, the shortfall can be drawn down
from the policy reserve. Second, the reserve is available to pay a claim
under the policy. Consequently, the “net amount at risk” under the policy
is 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 5TAXATION OF LIFE INSURANCE 1511
Many permanent insurance policies are designed so that the accumu-
lating fund grows over time to equal the total amount of the benefit
payable on death. At that time, the net amount at risk under the policy is
completely 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 surrender
value (CSV) of the policy. The CSV is the amount the policy holder is
entitled to receive upon the cancellation or surrender of the policy. Within
a few years after issue, the CSV of the policy typically approximates the
value of the related accumulating fund.
Following the introduction of the “term to 100” concept in the early
1980s, an increasing number of permanent policies have been designed
with CSVs significantly less than their related accumulating funds. Sim-
ply stated, term-to-100 is a permanent life insurance policy, generally
having guaranteed level premiums until age 100 and a guaranteed death
benefit, but little or no cash value. Where such a policy is surrendered or
lapses because of the non-payment of premiums, the excess of the accu-
mulating fund over the CSV is forfeited by the policy holder and becomes
available to pay the claims of other policy holders. The expected forfeitures
are factored into the pricing of such policies and premiums are reduced
accordingly. 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 simplistic
way to describe the complex nature of the contractual arrangements be-
tween the insurer and the policy holder.6 In reality, a life insurance policy
is a unified contract with the insurance and savings elements inextricably
linked. The financial consequences to the policy holder will depend on
whether the policy is retained and, if so, when and in what circumstances
benefits are paid. Furthermore, the policy holder cannot ordinarily with-
draw any of the cash values of the policy without adversely affecting the
value of the insurance protection. Ultimately, the financial results emerge
over a very long period.
The conundrum of whether permanent life insurance represents de-
creasing term insurance coupled with an increasing savings account or
the purchase of insurance protection on an instalment payment plan is
highlighted in figure 1 and figure 2.7 Both of these illustrations reflect a
5 Continued . . .
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 components
first appeared in M. Albert Linton, “Analysis of the Endowment Premium,” Actuarial
Notes feature (1919), 20 Actuarial Society of America: Transactions 430-43.
7 The conception of a life insurance policy as comprising two distinct elements of
protection and savings was challenged in Robert I. Mehr, “The Concept of the
Level-Premium Whole Life Insurance Policy—Reexamined” (September 1975), 42 The
Journal of Risk and Insurance 419-31.
(1995), Vol. 43, No. 5 / no 51512 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE
Figure 1 $1 Million Permanent Life Insurance Policy
(Endow at Age 100)
$1,200
$1,000
Net amount at risk
$800
Thousands
$600
$400
$200 Reserve
0
45 50 55 60 65 70 75 80 85 90 95 100
Age
$1 million permanent life insurance policy issued on a 45-year-old male
non-smoker. The policy shown in figure 1 has been designed to grow the
CSV to an amount equal to the face amount of the policy at age 100 (the
classic illustration of the decreasing term/increasing savings scenario).
The policy shown in figure 2 has been designed to build a reserve just
sufficient to defray future mortality costs and expenses so that the policy
will 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 fund
the policy shown in figure 2. The difference is only $40 per year. 8
The situation is further confused by the fact that the financial results
may differ considerably from those illustrated, depending on the actual
amount of policy dividends or interest credited to the accumulating funds
and the actual amount of mortality costs and expenses charged under the
contract. In fact, the policy shown in figure 1 could actually lapse with-
out value, or the policy shown in figure 2 could actually endow.
8 The insurance illustration is based on “Security Fund,” a universal life policy offered
by the Prudential of America Life Insurance Company (Canada). The interest rate credited
to the accumulating fund of the policy is assumed to be 6.5 percent annually. Annual
premiums are assumed to be payable until the insured’s age 100.
(1995), Vol. 43, No. 5 / no 5TAXATION OF LIFE INSURANCE 1513
Figure 2 $1 Million Permanent Life Insurance Policy
(Lapse at Age 100)
$1,200
$1,000
Net amount at risk
$800
Thousands
$600
$400
$200 Reserve
0
45 50 55 60 65 70 75 80 85 90 95 100
Age
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 not
be 2, could possibly turn out to be 4, but probably will not!
The relationship between the savings and protection elements of a life
insurance 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 the
hands 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 policy
holders?
Level Playing Field
The financial products and services provided by the life insurance indus-
try may compete either directly or indirectly with financial products and
services offered by other financial institutions. As the barriers separating
the traditional pillars of the financial services sector have come down, the
range 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 51514 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE to ensure that the tax system does not create an unfair competitive advan- tage for one financial institution over another. Regulatory Versus Tax Policy Issues The life insurance industry is closely regulated because of public concern over the protection of policy holders and the stability of the country’s fi- nancial institutions. The objectives of the regulatory authorities and those of the tax system are in conflict. How can such conflicting objectives be reconciled? For example, does a restriction on the deductibility of actuarial reserves by a life insurance company impair the strength of the company? Product Innovation and Development Fifty years ago, the development of a new life insurance product was a mammoth undertaking that required an incubation period of many years from conception to delivery. Today, the lead time for bringing a new product to market has shrunk to a matter of months. The challenge for the tax policy maker is to design a system that is based on sound fundamental principles and that is sufficiently flexible to adapt to a rapidly changing marketplace. The tax system should not impede new product innovation either by imposing a set of complex and detailed technical rules or by creating an unnecessary air of uncertainty over the application of the rules to new and innovative products. It is against this backdrop of tax policy issues and challenges that the evolution of Canada’s system for the taxation of life insurance is examined. BEFORE CARTER Industry Environment During the 20 years between the Canadian Tax Foundation’s establish- ment in 1945 and the mid-1960s, the Canadian life insurance industry could perhaps best be described as staid, conservative, and steeped in tradition. The industry was dominated by a relatively small number of large companies offering a narrow range of products. The products sold throughout this period included mainly whole life (participating and non-participating), limited pay life, endowment, and term policies. In 1960, whole life accounted for almost 75 percent of all individual life insurance owned by Canadians. Product pricing was typically based on level premiums fixed at the time the policy was issued. The amount of death benefit was ordinarily established at the time of issue and remained unchanged throughout the duration of the contract. The CSV of the policy at any point in the term of the contract could be determined at the time the policy was issued. New product introductions were rare, and existing products were repriced only every 5 to 10 years. The policies were characterized by complex contractual language, lit- tle disclosure of the design elements or factors involved, and very limited flexibility or available options. (1995), Vol. 43, No. 5 / no 5
TAXATION OF LIFE INSURANCE 1515
Tax System
Life insurance was virtually exempt from income tax at both the company
and the policy holder level until 1968. The Income War Tax Act of 1917,
the first income tax statute in Canada, provided an explicit exemption for
policy holders on
the proceeds of life insurance policies paid upon the death of the person
insured, or payments made or credited to the insured on life insurance
endowment or annuity contracts upon the maturity of the term mentioned
in the contract or upon the surrender of the contract. 9
A tax exemption was also provided for the income of life insurance
companies “except such amount as is credited to shareholders’ account.”10
Consequently, only the net earnings of stock life insurance companies
which were allocated to shareholders (whether or not distributed) were
subject to corporate income tax. Mutual life insurance companies, having
no shareholders, were fully exempt.
When the Income War Tax Act was overhauled in 1948, this same
principle was carried forward. However, the explicit exemption was with-
drawn. Instead, the exemption was implicit in the definition of the taxable
income 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 policy
holder 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 policies
are exempt from taxation, and properly so.”12 On the basis of this phi-
losophy, gains realized on death, maturity, or surrender of life insurance
policies 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 specified
period was subject to tax. Life annuities with guaranteed periods were
taxable only on the interest element during the guaranteed term but on the
full amount thereafter. This procedure raised a public outcry of dissatis-
faction and led to the appointment of a royal commission on the taxation
of annuities. The Ives commission recommended that annuities be taxed
on the principle that a portion of each payment is in part a tax-free return
of capital and in part taxable interest income. A simple rule of thumb was
adopted to calculate the tax-free capital element to be the level amount
obtained by dividing the purchase price by the term (in years) or, in the
case 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 51516 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE
for the taxation of annuities were adopted in 1945 and survive today as
the basis for the taxation of prescribed annuities.
Although the interest element of annuity payments was taxable, there
was no provision in the legislation to tax the proceeds received on the
surrender of a deferred annuity contract before the commencement of
periodic payments. This loophole eventually led to a widespread practice
of purchasing deferred annuities with the intention of cancelling them
before maturity in order to receive tax-free gains. In 1963, the Income
Tax Act was amended to block this perceived abuse by taxing as interest
income any gain realized on the surrender of an annuity contract, other
than on death.14
THE 1960S
Industry Environment
During the 1960s, the winds of change began to blow through the life
insurance industry. The economic climate was undergoing a fundamental
change as interest rates started to rise, fuelled by intensifying inflationary
pressures. Life insurance policy holders were becoming increasingly dis-
enchanted with traditional permanent insurance as an investment. More
and more whole life policy holders were advised to buy term and invest
the difference. By the end of the decade, the percentage share of the
individual life insurance market represented by whole life policies had
dropped from about 75 percent to just over 60 percent.
The availability of increasing computing power permitted the faster
development and maintenance of new and more complex products. The
pricing of existing products was also changed more frequently in re-
sponse to changing economic conditions. Insurance mortality rates were
improving with advances in medical science and health care, resulting in
lower insurance costs. Competition within the industry was also intensi-
fying as new and smaller companies entered the market and more
foreign-owned insurance companies ventured into Canada. These newer
entrants into the market could afford to pursue market share by develop-
ing new and competitive products without the concern about their possible
impact 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 of
techniques had been designed to enable shareholders to convert taxable
dividend 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 5TAXATION OF LIFE INSURANCE 1517
strategies were threatening to seriously undermine the integrity of the entire
structure. A royal commission on taxation (the Carter commission) was
appointed 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, and
create an entirely new tax structure built on the commission’s concepts of
equity and neutrality. 15
The Carter report was a watershed in the evolution of tax policy in
Canada. The commission forever changed the environment for the taxa-
tion of life insurance. Particular recommendations put forward in the
Carter report must be considered in the context of the full integrated
model tax system proposed by the commission. Simply stated, a funda-
mental guiding principle for the new tax system was that taxes should be
imposed 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 all
increases in economic power into tax. Such a tax base would also have the
very desirable ancillary benefit of substantially eliminating the uncertainty,
and the various opportunities for tax minimization and avoidance, that we
have found in the present system, because virtually all net gains would be
taxable to residents at full personal rates.16
On the basis of this “a buck is a buck” concept of the tax base, the
commission’s recommendations for the taxation of life insurance should
not have come as any great surprise. In summary, the commission
recommended:17
1) Life insurance companies should be taxed at regular corporate rates
on operating income not passed through to policy holders. However,
through the gross-up and credit mechanism proposed for taxing dividend
income, the corporate tax rate would ultimately be adjusted to the per-
sonal tax rates of individual shareholders. A similar process should apply
to mutual insurance companies with respect to gains held for the benefit
of participating policy holders.
2) Premiums paid for a life insurance policy (other than for employer-
sponsored group life insurance) should not ordinarily be deductible in
computing taxable income.
3) In general, investment income accumulated for the benefit of the
policy holder should be included in the policy holder’s income in the year
it is accumulated in the hands of the insurer. The commission recognized
that 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 51518 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE of computation for allocating to individual policyholders the investment income credited to policy reserves.”18 As an alternative, the commission proposed a system of withholding taxes under which the insurer would pay tax on investment income cred- ited to policy reserves when accrued; the policy holder would receive a credit at the time benefits were paid (the blueprint for the investment income tax). 4) Policy dividends should be included in the income of the recipient. 5) Mortality gains and losses should eventually be included in the computation of the income of policy holders. However, the commission did not recommend the immediate inclusion of mortality gains and losses in the tax base, primarily because the other recommendations involved such a substantial change in the tax treatment of life insurance. The life insurance industry was the first to feel any real impact from the Carter report. In his 1968 budget, Finance Minister Edgar Benson proposed 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. Two new separate taxes were proposed, one at the policy holder level and one at 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 save in the form of insurance policies and those who save in other forms, to levy some tax on the investment income which policyholders receive through the insurance companies. 19 Mr. Benson also said that his proposals would constitute “a much simpler and more practical method” than the method recommended by the Carter commission, and should “achieve substantially similar equity.”20 After intensive consultation with the life insurance industry, the budget proposals were implemented, with some modifications, through amend- ments to the Act and the regulations in 1969. The new taxes on life insurance introduced in 1969 are summarized below. Policy Holder Gains Gains realized by a policy holder on the surrender or maturity of a life insurance policy (but not on death) became fully taxable. The accumu- lated policy reserves, when received as part of the benefit payable upon death, continued to be tax-free, as were pure mortality gains. Carter’s recommendation to tax income credited to policy reserves in the hands of policy 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
TAXATION OF LIFE INSURANCE 1519
The amount to be included in taxable income upon the disposition of a
policy 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 the
aggregate of premiums paid. Policy dividends were treated first as a re-
duction of the ACB and therefore were not currently taxable until such
time as the total dividends received exceeded the total premiums paid or
until the policy was surrendered or matured (other than as a consequence
of death).
Special grandfathering treatment was accorded to life insurance poli-
cies that were in force on October 22, 1968, to avoid retroactive taxation
of gains already accrued.
Segregated Funds
A segregated fund policy is a variable life insurance contract under which
a portion of the premium is placed in a separately administered invest-
ment portfolio. The proceeds receivable by a policy holder under such a
policy at any time will depend on the value of the securities held in the
segregated fund.
At the urging of the life insurance industry, the government adopted a
flowthrough treatment for segregated fund policies. Provision was made
for the insurer to allocate investment income earned on the segregated
fund to the policy holder on an annual basis. The character of the invest-
ment income as dividends, interest, and income from other sources was
preserved and taxed as such in the policy holder’s hands. The proportion-
ate amounts of foreign taxes paid and depletion allowances were also
allocated 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 investment
products that were substantially similar in nature.
Investment Income Tax
In 1968, the government had concluded that there was no “simple and
practical method of taxing in the policyholders’ hands the investment
income which benefits them by way of reduced premiums or increased
policy dividends.”21 To take the place of a tax on the individual policy
holders, a 15 percent tax was imposed on the taxable Canadian invest-
ment income of the insurance companies. The calculation of this investment
income tax (IIT ) was not simple and, in many respects, was very arbitrary.
The starting point was to allocate gross investment income between
Canadian and foreign life insurance operations (excluding income related
to segregated funds, registered retirement funds, and grandfathered poli-
cies). Deductions were then allowed for investment expenses and a purely
arbitrary 50 percent of the company’s general expenses incurred in its
Canadian operations (including commissions but excluding premium taxes).
21 Ibid.
(1995), Vol. 43, No. 5 / no 51520 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE 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 element of annuity payments and taxable gains realized on the surrender or matu- rity of policies were deducted in calculating taxable Canadian investment income. The result of this deduction was that the company recovered the tax it paid on investment income when such amounts became taxable to the policy holder. A deduction was also allowed for the amount of income subject to regular corporate income tax.22 Corporate Income Tax The 1969 amendments brought insurance companies into the tax net for the 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 on business 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 included the following. Canada-Only Principle Only income earned from carrying on a life insurance business in Canada was 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 taxes paid. Here again, extraordinarily complex and often arbitrary rules were developed 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 internationally through foreign branches. Such companies may have been placed at a severe competitive disadvantage if a worldwide basis of taxation were abruptly imposed. Capital Gains The 1969 amendments specifically provided that the investment income of a life insurance company would include realized gains and losses and the 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
TAXATION OF LIFE INSURANCE 1521
mainly bonds, debentures, and mortgages, but not equities.25 For most
other companies, such amounts were considered capital gains or losses
and consequently were not taxable.
Policy Reserves
Regulations were developed in 1969 to determine the maximum tax actu-
arial reserves ( MTAR) allowable in calculating a life insurance company’s
income for tax purposes. 26 The MTAR were not necessarily the same as
reserves reported in the company’s annual filings with the federal regula-
tors. The government was concerned that the statutory reserves were
ultraconservative 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 calculated
pursuant to the net level premium method, using the same interest and
mortality assumptions as used for statement reserves. In general, reserves
for 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 additional
contingency reserves. Industry representatives sought recognition of the
highly contingent nature of mortality risks and the potential of experienc-
ing adverse results with regard to investment yields and expenses over
the long-term duration of a life insurance contract. However, the govern-
ment did not agree; in its view, there was already some margin for
contingencies in the MTAR, and other types of corporations are not per-
mitted deductions for contingency reserves. The government also felt that
the effects of any unusual losses could be cushioned by an effective
unlimited carryforward of losses available to life insurance companies
through their discretionary ability to claim as a deduction any amount of
policy reserves up to the MTAR.
Policy Dividends
Dividends paid to the owners of participating life insurance policies were
deductible, subject to specified limits.27 In general terms, the limit was the
pre-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 made
pursuant 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 51522 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE life business. The deduction was available in advance in the form of a reserve for future policy dividends that were payable out of current earnings. Deduction for Investment Income Tax The IIT was allowed as a deduction in computing income subject to the basic corporate tax.28 Because the amount of such income was also de- ductible in determining the base on which the IIT applied, the determination of each level of tax required a complex circular calculation. Dividends Paid to Shareholders Before 1969, tax was payable by stock life insurance companies on divi- dends paid or credited to shareholders. To preserve continuity and to ensure that large accumulations of surplus before 1969 did not escape tax, the 1969 amendments provided that subsequent dividends would also trigger corporate tax to the extent that they exceeded earnings accumu- lated after the new system was implemented.29 THE 1970S Industry Environment Economic Conditions The 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 over 11 percent by 1979. The average annual increase in the consumer price index, 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 traditional life insurance policies offered sufficient economic sensitivity and flex- ibility. Sales of both participating and non-participating whole life insurance policies began to dry up as consumers perceived better finan- cial returns available through other savings and investment products. At the end of 1979, more than half of all individual life insurance owned by Canadians was in the form of term policies.30 Insurers also began to experience cash flow problems as dissatisfied policy holders either surrendered their policies or took out policy loans at interest rates substantially below market. Inflation was also driving up operating costs at a time when premium income was either static or fall- ing for some companies. Product Development To 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
TAXATION OF LIFE INSURANCE 1523
to change. Innovative new insurance product ideas began to emerge across
North America in the early 1970s. This trend intensified throughout the
decade, and precipitated a revolution in product design. 31 Preferred
non-smoker mortality rates were introduced, thereby substantially lowering
premiums for non-smokers and increasing premiums for smokers. A new
money concept was developed, whereby the returns credited to the policy
reserve were based on the yields available from the current investment of
premium revenues. Previously, amounts credited to policy reserves were
based on the company’s portfolio average rates of return. Because new money
rates could not be guaranteed for the duration of the contract, policies be-
came variable or adjustable. Depending on current investment returns, the
premiums 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 dividends
to 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 Standards
Before 1978, federal insurance legislation required that the superintend-
ent of insurance prescribe the mortality and interest rate assumptions to
be used by insurers in calculating their policy reserves. Typically, these
were based on the Commissioners 1958 Standard Ordinary Mortality Table
and an interest rate of between 3 and 4 percent—very conservative
assumptions.
In 1978, the legislation was amended to shift the responsibility of
establishing adequate policy reserves, including the underlying mortality
and interest rate assumptions, to a valuation actuary appointed by the
directors of the insurance company. The determination of policy reserves
thus became much more flexible, and a great deal of reliance was placed
on the professional judgment of the valuation actuary.
The deregulation of reserves in 1978 paved the way for much of the
product innovation over the next 15 years. In addition, as the competitive
pressures escalated both between the insurance industry and other finan-
cial institutions and within the industry among companies competing for
market share, policy reserves became considerably less conservative after
1978. This has resulted in significantly increased price competition in the
life insurance marketplace.
Tax System
The 1969 tax reform for the insurance industry turned out to be a trial run
for 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 late
1970s, see John A. Bowden, “The Role of Life Insurance Products in Estate Planning
Following the Federal Budgets of November 1981 and June 1982,” in Report of Proceed-
ings of the Thirty-Fourth Tax Conference, 1982 Conference Report (Toronto: Canadian
Tax Foundation, 1983), 833-43.
(1995), Vol. 43, No. 5 / no 51524 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE with the release of a white paper in November 1969.32 The white paper sparked widespread public debate and exhaustive hearings before com- mittees of both the House of Commons and the Senate. 33 This process culminated in 1971 with the introduction of Bill C-259, which contained 750 pages of detailed amendments to the Income Tax Act—the largest income 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 the trauma of becoming subject to income tax for the first time, the life insurance industry was left relatively untouched by the 1971 tax reforms. In 1974, the government introduced a special $1,000 tax exemption for interest income earned by individuals in recognition of the adverse im- pact of inflation on savings. 34 The exemption was expanded in 1975 to include dividend income and in 1977 to include capital gains. With the IIT imposed at the corporate level, there was no easy way to extend the benefits 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 Changes The March 1977 budget proposed two significant changes relating to the taxation of investment income earned inside life insurance policies. First, the IIT (imposed under part XII of the Act) was to be repealed. Explaining the proposed repeal, the minister of finance said: [W]hen the government introduced the $1,000 exemption for interest and dividend income, the balance between competing forms of savings may have been upset. Therefore, the Part XII tax will be repealed and the invest- ment income on life insurance policies and annuities will be allowed to accumulate tax-free for the benefit of the policyholder.35 The second change, intended as the quid pro quo for the IIT, was to tax the investment gain implicit in a life insurance policy upon the death of the insured in the same manner as it was taxed upon the surrender or maturity of the policy. The reaction of the life insurance industry to this second proposal was swift and violent. The proposal, variously dubbed the “tax on death” and the “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 and Commerce, Report on the White Paper Proposals for Tax Reform Presented to the Senate of Canada (Ottawa: Queen’s Printer, 1970). 34 SC 1974-75-76, c. 26, section 70, effective for the 1974 and subsequent taxation years. 35 Canada, Department of Finance, 1977 Budget, Budget Document, March 31, 1977, 43. (1995), Vol. 43, No. 5 / no 5
TAXATION OF LIFE INSURANCE 1525
study.” 36 Surprisingly, the government proceeded with the repeal of the
IIT . As a result, after 1977 the investment income accumulated for the
benefit 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 amounts
received from a policy loan made after March 31, 1978 as proceeds of
disposition of an interest in the policy. 37
The 1969 amendments did not deal specifically with policy loans. It
was, and still is, an open question whether a policy loan is a loan in the
strict legal sense. In some cases the arrangement may be a true loan made
by the insurance company from its general funds and secured by the
policy. 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 effectively
can defer the payment of tax until the policy is surrendered or matures. If
the policy is left in force until death, tax is avoided altogether. The 1977
amendment was intended to block this perceived abuse.
Changes to the segregated fund rules were also made in 1977. The
original 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 in
an unincorporated mutual fund. The 1978 amendments deem a segregated
fund of a life insurer to be a separate inter vivos trust. The annual income
of the fund is deemed to be distributed to the policy holder as the deemed
beneficiary of the trust.38 These changes finally put segregated funds on
an even footing with mutual fund trusts.
1978 Company Changes
By 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 February
1978, the Department of Finance stated: “The reserves available to life
insurers under the income tax law in force to the end of 1977 . . . were
clearly excessive.”39 The main reason for this excessive level of policy
reserves was the use of the net level premium method of calculation. Under
this method, a constant proportion of each premium is set aside in the
reserve. This does not recognize that the early premiums are used by the
insurer to fund heavy front-end distribution and administrative costs. Since
such 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 51526 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE
their deduction plus the deduction for a net level premium reserve resulted
in a significant tax loss in the year the policy was issued. A constantly
growing insurance business using the net level premium reserve method
tends to produce continuing tax losses and a growing tax deferral.
The 1978 amendments replaced the net level premium method with the
full preliminary term method for calculating policy reserves. Under the full
preliminary term method, no reserve is permitted in the year the policy is
issued. This tends to balance the deduction for acquisition costs with the
premium 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 mortality
assumptions.
The rules for the allocation of a life insurance company’s income be-
tween Canadian and foreign operations were also substantially modified
in 1978. Significant shortcomings had been discovered in these provi-
sions, which permitted companies to allocate a disproportionately large
amount of income offshore, avoiding the incidence of Canadian tax.40
THE 1980S
Industry Environment
Economic Conditions
Annual inflation rates continued to rise in the early 1980s and again
reached double digits. The yield on long-term Canada bonds also sky-
rocketed to over 15 percent in 1981. However, by 1983 the worst recession
since 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. Interest
rates also declined, although somewhat more slowly; the yield on long-term
Canada bonds settled at just under 10 percent by 1990.
Interest-Sensitive Products
The revolution in life insurance product design was in full swing in 1980.
The new money concept, which shifted some of the investment rewards
and risks back to the policy holder, was a major breakthrough in policy
design. A proliferation of interest-sensitive products hit the market in the
early 1980s, capitalizing on the high interest rates then available and the
expectation that such high rates might continue indefinitely.
The new money concept, first introduced in the Canadian market in the
mid-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 Canadian
Tax 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 5Vous pouvez aussi lire
