Tax considerations for life insurance premiums under collateral assignment for business bank loans

Lions Financial stands at the forefront of assisting businesses in navigating the intricate realm of life insurance management. We specialize in addressing complex challenges, particularly in collaborating with Certified Public Accountants (CPAs) to optimize the tax structuring of insurance policies. Our expertise extends to tailoring life insurance solutions that align seamlessly with your business’s financial strategies and objectives. Engaging with Lions Financial ensures a comprehensive approach to life insurance, integrating risk management with astute fiscal planning to enhance the overall financial health of your business.

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.

Would the premiums be considered tax deductible?

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

What are the requirements for deductibility?

In order for all or a part of premiums payable on an insurance policy to be deductible, the following requirements must be met in accordance with 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; and
4. the assignment must be required by the lender as collateral for the debt.
5. 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 owed 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

Deductible for the Year Generally, in order for interest on debt to be deductible under the Act, several 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. The latter requirement generally means that the borrowed funds must be used in the operation of a business or to earn investment income, not for purchasing no income-producing property or for 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. A written request from the lender that a life insurance policy be collaterally assigned to secure the loan is generally sufficient evidence that this requirement has been met.

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.

What are the requirements, limitations, & restrictions for collateral assignment of life insurance?

• The borrower must be the policy owner, who may or may not be the insured.
• The collateral assignment may be against part or all of the policy’s value, and if any amount remains, beneficiaries receive the difference.
• Full repayment of the loan terminates the assignment.

1. BENEFICIARY AND POLICY OWNER REQUIREMENTS

Policy-owners of a life insurance policy that qualifies for collateral assignment must be the owner of the policy. They do not necessarily need to be the insured or the beneficiary, but they must be the owner of the policy.

The policy owner must maintain payment of all premiums in order for this policy to remain in place as collateral.

2. LENDER RIGHTS

If you default on your loan, the bank reserves all rights to utilize your life insurance policy’s death benefit as a form of repayment for your defaulted payments.

They reserve the right to take from your cash value on permanent life insurance policies.