Proposed Exempt Insurance Policy Rules Explained

The draft tax legislation released late in August changes the rules regarding the taxation of the income earned on the savings in a life insurance policy.

Those rules differ depending on an exemption test that is applied each year. This test measures whether policy is exempt or “protection-oriented” or non-exempt, which would mean it’s savings-oriented.

When income is earned in a non-exempt policy, it’s taxed as interest income, on an accrual basis at the policyholder level. But when income is earned in an exempt policy, it’s subject to a 15% minimum tax called the Investment Income Tax. That tax is levied on the insurer, not the policyholder.

Because these rules are old – last introduced in the early 1980s – the government has “modernized” them with these new legislative proposals, which also amend the rules applying to the determination of the capital element of annuity payments for life contingent annuity contracts. The changes come with grandfathering provisions for existing policies. A table to summarize the proposal was included with the legislation.

The changes are made to the Income Tax Regulations in subsection 306(1) and sections 307 and 1401. In general they will apply to policies issued after 2016. However, some changes apply in subsection 148(11) to policies issued before 2017. In essence, a new pre-testing rule on the policy anniversary will require that it is reasonable to expect that the policy and the Exempt Test Policy savings requirements will be met on the next policy anniversary. This shortens the pre-testing period from the prior rules, and puts into place the requirement for projections using the most recent values for variables that enter into the calculation.