For the majority of cases in Canada, premiums paid on life insurance are paid by individuals and don’t count as a tax-deductible expense. But a specific provision within the Income Tax Act provides a possibly overlooked opportunity for life insurance premiums to be used for deductions.
According to a recent piece by Barrett Tax Law, one of the most technical provisions of the Income Tax Act, paragraph 20(1)(e.2), opens the door for a person or business to deduct the reasonable cost of key person life insurance in the event that it is used as collateral in a business financing agreement.
“Aside from their direct value to [a] company, many key employees have a value to financial institutions which often agree to finance a company on the basis of their faith in that person and their value to the business,” the firm explained. “As part of a financial arrangement based in part on an individual's merit, credentials or experience, the lending institution may require collateral to compensate in the event something happens to that person.”
That collateral may be provided in the form of key person insurance, which may be a new life insurance policy the company takes out or an already existing policy on the individual’s life. In either case, what’s important is for the policy to be assigned to the lending institution, thus providing it with protection to ensure that the loan extended can still be repaid even if something were to happen to the individual.
“In such a case, paragraph 20(1)(e.2) becomes a valuable tool for the borrower,” the firm said. “[T]his provision allows the borrower to deduct from their income, reasonable costs of a life insurance policy which in turn facilitated the financing with the lending institution.”
From a tax perspective, a key person insurance policy assigned to a financial institution to earn income or facilitate a business loan is different from one bought specifically to mitigate the loss of a key person. As the experts at Barrett Tax Law explained, premiums paid toward a policy assigned to a lender are used to secure loan financing, which is in turn presumably used to earn income for the business.
“Similar to any other reasonable expense used to earn income, it is deductible when reporting at the end of each tax year, but only by virtue of paragraph 20(1)(e.2) of the ITA,” they said.
According to the firm, proprietors or even sophisticated business owners may overlook paragraph 20(1)(e.2) because it is buried deep in the Income Tax Act. Even those who know about it, they said, may overlook its applicability to their situation because of its technical nature.
“A borrower may not understand that using a life insurance policy as collateral changes some of its tax qualities,” the firm said.
They highlighted key requisites for businesses to deduct premiums paid toward key person life insurance used as collateral:
- The life insurance policy must be assigned to a “restricted financial institution” as defined in the Act;
- The interest payable in respect of the borrowing must be deductible “but for” certain provisions in the act, which includes a reading and understanding of subsections 18(2), 18(3.1), and ss. 21 and 28, and possibly other provisions with reference to other aspects of the Act;
- The lending institution must “require” the life insurance collateral as part of the loan agreement; and
- The taxpayer must distinguish between deducting the “net cost of pure insurance” and the premiums, then make sure the amount is reasonable with regard to the loaned amount.