The Tax Considerations For Life Insurance Premiums Under Collateral Assignment For Business Bank Loans

Would the premiums be considered tax deductible?

As a general rule, premiums paid under a life insurance policy are not an allowable deduction for income tax purposes. An exception may arise where a taxpayer borrows money for the purpose of earning income and the lender requires the collateral assignment of a life insurance policy as security for the loan.

Income Tax Act reference: 

A life insurance policy used as collateral security may be an allowable deduction in paragraph 20(1) (e.2) of the Income Tax Act (the “Act”).

What are the requirements for deductibility?

The deduction policy for all or part premium payable should meet the following requirements according to paragraph 20(1) (e.2) of the Act:

1. The policy must be assigned to the lender
2. The lender must be a “restricted financial institution
3. The interest payable in respect of the debt would, but for certain provisions in the Act, be tax deductible in computing income for the year
4. The assignment must be required by the lender as collateral for the debt.

 1. Policy Assigned to the Lender

The collateral assignment of a life insurance policy is similar in concept to mortgaging real property. The owner/assignor retains certain ownership rights in the policy, but the “value” of the policy (i.e. the cash value or the death benefit) must first be used to satisfy the debt owing to the lender/assignee. Any remaining amount may then be paid to the owner/assignor, or upon death of the life insured under the policy, to the designated beneficiary. This is to be distinguished from the absolute assignment of a life insurance policy, whereby the assignor transfers all ownership rights in the policy to the assignee, retaining no residual interest.

2. Lender is a Restricted Financial Institution (“RFI”)

An RFI is defined in subsection 248(1) of the Act as a bank, trust company, credit union, insurance corporation, a corporation whose principal business is the lending of money or purchasing of debt obligations at arm’s length, or a controlled subsidiary company of one of the above.

 As a result of this requirement, insurance used as collateral security in respect of shareholder loans would generally not be eligible for the deduction.

3. Interest Payable on Debt is Tax Deductible for the Year

In order for interest on debt to be deductible for the year under the Act, these conditions must be met: there must be a legal obligation to pay interest; interest must be paid or payable in respect of the year that the deduction is taken; the amount of interest must be reasonable in the circumstances; and, the borrowed money must be used for the purpose of earning income from property or from a business. 

This requirement is for the borrowed funds to be used solely for the operations of a business or to earn investment income, not for purchasing property liabilities or personal expenses.

4. Collateral Assignment of Insurance Policy Required by Lender to Secure Loan

The lender must require, not merely “appreciate”, security in the form of life insurance. To meet this requirement, a written request from the lender that a life insurance policy must be collaterally assigned to secure the loan.

What is the amount deductible?

Assuming all of the above requirements have been met, paragraph 20(1) (e.2) of the Act provides that the amount deductible in respect of a policy for a taxation year is determined as follows:

The portion of the lesser of:

(i)-The premiums payable by the taxpayer under the policy in respect of the year, and

(ii)-The net cost of pure insurance of the policy for the year as can reasonably be considered to relate to the amount owing from time to time during the year by the taxpayer.

Who qualifies for collateral assignment of life insurance?

Any policyholder that has a permanent or term life insurance policy can qualify for collateral assignment.

Not every company allows collateral assignment of life insurance policies, and therefore it is best that you speak with your life insurance provider to see what their limits are with regard to Collateral Assignment.

However, most life insurance companies are equipped to handle this easily.

Many life insurance providers do not care how you use the policy, as long as it is in a legal fashion, and they will likely sign your application for collateral assignment quickly and with minimal friction.