Principal Issues: General comments on the taxation of a return of premium benefit on the disposition of a life insurance policy.
Position: See document
Reasons: The legislation
April 21, 2008
XXXXXXXXXX
Dear XXXXXXXXXX :
XXXXXXXXXX , Member of Parliament, forwarded to me a copy of your letter, which I received on February 14, 2008, concerning the tax treatment of the disposition of a life insurance policy with a return of premium benefit.
Without more background information, I cannot comment on the specifics of your situation. I can, however, offer the following general comments on the taxation of life insurance policies.
The type of policy you describe generally provides for two benefits that the insurance company provides in exchange for the premiums paid by the policyholder. One of the benefits is the right for the named beneficiary under the policy to receive the face amount of the policy if the individual insured under the policy dies during the period that the policy is in force. The other benefit is the right to receive a payment from the insurer if the individual insured under the policy is still living at the time the policy matures. This second benefit is what is commonly referred to as a return of premium benefit.
A gain that is realized on the disposition of a life insurance policy is included in calculating the policyholder's income in accordance with paragraph 56(1)(j) of the Income Tax Act. Subsection 148(9) of the Act gives definitions and calculations that relate to determining any gain resulting from the disposition of a life insurance policy. A disposition of a life insurance policy is defined to include the dissolution of a policy when it matures.
If a life insurance policy has been disposed of, the amount of any gain is the amount by which the proceeds of the disposition exceed the adjusted cost basis of the policy. Under the definition of "proceeds of disposition" in subsection 148(9) of the Act, the payment received as a refund of premium would be considered to be the proceeds of disposition of the policy.
The adjusted cost basis of a life insurance policy is also determined by a formula set out under subsection 148(9) of the Act. In general terms, the adjusted cost basis to the original policyholder will be the amount by which the cash premiums paid by the policyholder, and any income in respect of the policy that has previously been reported for tax purposes, exceeds an amount referred to as the "net cost of pure insurance" under the policy.
Section 308 of the Income Tax Regulations sets out the rules for calculating the net cost of pure insurance of a taxpayer's interest in a life insurance policy. The net cost of pure insurance represents the cost to the policyholder to have the death benefit coverage during the years that the policy was in force, and therefore reduces the amount that can be returned to the policyholder on a tax-free basis when the policy matures. Your insurer should be able to provide you with information on how it calculated the proceeds of disposition, adjusted cost basis, and the gain on the disposition.
I understand that you feel the taxation of the return of premium benefit is unfair and should be reconsidered. The CRA is responsible for administering the tax system and applying current tax legislation. Any changes to policy or amendments to legislation would have to be proposed by the Minister of Finance and approved by Parliament. It is therefore appropriate that you wrote to the Honourable James M. Flaherty, Minister of Finance.
I appreciate the opportunity to respond to your concerns.
Sincerely,
The Honourable Gordon O'Connor, P.C., M.P.
c.c.: XXXXXXXXXX
Income Tax Rulings Directorate
2008-026994