FEB 5, 1991
HEAD OFFICE Financial Industries Division J.P. Dunn (613)957-8961
SUBJECT: Payment of Life Insurance Premiums with Annuity Receipts
We are writing in response to your memorandum of March 28, 1990 concerning certain life insurance policies which are being purchased by corporations to insure their key personnel. We apologize for the delay in replying.
In the case described by J. Smith of your office, the life insurance premiums are paid from the receipts of an annuity contract which is purchased by the corporation from the life insurer. In the example provided, a ten year annuity is purchased by the corporation for $333,165 which earns an aggregate amount of annuity income over that period of $188,098. Over the same ten years, the corporation pays, to the insurer, administration fees related to the annuity of $152,915 with the net difference of $35,183 reported by the corporation as annuity income. Consequently, the total payments constructively received by the corporation from the annuity and used to fund the insurance premiums total $368,348 which amount is composed of the annuity principal and income payments of $333,165 and $188,098 respectively less the administration fees paid of $152,915. The insurance policy is, apparently, totally "paid-up" after the ten annual payments made through the annuity receipts.
The corporate policyholder does not deduct the payment made to purchase the annuity and, as noted above, includes in income only the net amount earned after deduction of the annual administration fees. Furthermore, the annuity schedule provided in your example indicates an annual interest rate to be paid of 10.75%, however, subsequent to the payment of the annual administration fees, the effective annual yield is reduced to approximately 2%. The result of structuring the annuity and life insurance premiums in this manner is, as stated by the Toronto District Office, that by accepting a low effective annual yield on the annuity, the taxpayer is able to deduct a portion of the life insurance premiums which would not otherwise be tax deductible. We are assuming that the deductible portion referred to is the annual administration fee related to the annuity.
The district office has posed three questions with respect to this situation;
1) Has this been established to be acceptable practice by life insurance companies?;
2) If not, how do you determine how much of the administration fee to disallow or, what is considered to be a "reasonable" return on such annuities?; and
3) Should the administration fee be found to be unreasonable, which of section 67 or subsection 18(1) of the Income Tax Act (the "Act") would be the appropriate provision to disallow the unreasonable portion of that fee?
With respect to the first question, the problem to be addressed is the acceptability of the practice for income tax purposes. The concern which does arise in this particular case is whether the administration fee charged against the annual annuity income represents the administration costs related to the life insurance policy. Such costs generally include the life insurance sales commission, the fee charged by the insurer to administer the policy and a profit element for the life insurer. Normally, these amounts are included as a component of the annual life insurance premium, none of which is deductible for income tax purposes.
In the case at hand, however, the annuity earns income which is subject to tax and, consequently, the administration fee may be a deductible expense for tax purposes which is not denied by paragraph "18(1)(a) of the Act as the fee is an outlay or expense incurred by the taxpayer for the purpose of producing income from property. Presumably, the taxpayer is relying specifically upon paragraph 20(1)(bb) of the Act in this regard. Section 67 of the Act will restrict the quantum of the administration fee which is deductible for tax purposes to the amount which is reasonable in the circumstances.
As you have inferred, the primary problem to be resolved is the extent to which the administration fees relate to either the annuity contract or the life insurance policy as this determination will primarily govern the deductibility of the expense. Subsequently, it is necessary to determine, for the purpose of section 67 of the Act, if the expense claimed is reasonable. Although you have asked our opinion regarding a "reasonable return" on the annuity, we would consider that the "reasonable" test would be better applied to the administration fee expense as there is no provision in the Act which would impute a reasonable rate return on the annuity whereas section 67 deals specifically with expenses which are not reasonable having regard to the particular circumstances.
The first question to be resolved however is whether the administration fees relate wholly to either the annuity or the life insurance policy or partially to both. In order to resolve this question, a review could be made of similar products sold separately by the pertinent life insurer to determine the method employed by the insurer to account for sales commissions and administration costs related to the individual products and these findings then compared to the amounts in your example. We would also note that there is no indication whether any portion of the life insurance premiums in the example is being allocated as an administration charge related to that product and, consequently, similar policies would be reviewed to determine the premium payment required to fund both the insurance coverage and the administration costs.
If it is found that the administration fees relate wholly or primarily to the life insurance coverage rather than the annuity, it is our opinion that there would be support for a proposed reassessment of the taxpayer on the basis of both paragraph 18(1)(a) and section 67 of the Act and we would offer the following comments in that regard.
Whether a particular expense is or is not reasonable is a question of fact to be determined after examination and consideration of all the surrounding circumstances. Notwithstanding that the annuity contract may provide for the payment of the administration fees, it may be found subsequent to examination that they are not reasonable in the circumstances. Furthermore, as noted previously, it may also be found that the attendant life insurance policy contains no provisions in its premium pricing for sales commissions or other administrative costs, or that any provision for such costs is minimal in comparison to similar products sold without the accompanying annuity. We would emphasize that, should the Department consider challenging the administration fees as being unreasonable in the circumstances, sufficient objective documentary evidence must be obtained to support such a conclusion. This point is especially relevant in a situation such as this in which the parties to the contract appear to deal at arm's length.
We trust that our comments are of assistance to you.
Chief Financial Institution Section Financial Industries Division Rulings Directorate