On January 15, 2008, the Federal Court of Appeal upheld a decision by Justice Hershfield of the Tax Court of Canada, finding for the respondent, the National Life Assurance Company of Canada (National Life), in respect of policy reserves taken for its 1997 and 1998 taxation years. Now part of Industrial Alliance Insurance and Financial Services Inc., National Life, at the time, was a subsidiary of the company.

The Background

At issue was one of National Life's segregated fund policies, UltraFlex, which offers the policyholder a choice of both fixed-term investments held in the company's general fund and variable investments held in its segregated funds. Subparagraph 138(3)(a)(i) of the Income Tax Act (Canada) (the Act) allows a life insurer, in computing its income for a taxation year from carrying on its life insurance business in Canada, to deduct an amount that it claims as a "policy reserve" in respect of its life insurance policies. The Income Tax Regulations (the Regulations) prescribe the formula for calculating the policy reserve (the maximum tax actuarial reserve or MTAR) that may be deducted. The formula for the amount in respect of post-1995 life insurance policies, relevant in this appeal, is found in subsection 1404(3) of the Regulations. The only item in the formula relevant for this appeal was the "A" amount. The "A" amount is defined as the lesser of the total of the reported reserves or the policy liabilities (as defined under the Act) of National Life at the end of the year in respect of those policies; however, this amount is modified by paragraph 1406(b) of the Regulations. Paragraph 1406(b) requires that the "A" amount be determined "without reference to any liability in respect of a segregated fund (other than a liability in respect of a guarantee in respect of a segregated fund policy)." It is the application of this provision to the company's policy reserves as reported to the Superintendent of Financial Institutions (the "reported reserves" in the formula) in respect of its potential liability under the UltraFlex policies that was in issue.

The actuary makes a number of computations to calculate this potential liability for each UltraFlex policy. The computations with respect to the company's liability in respect of any fixed-term investments were not in issue, as the focus of paragraph 1406(b) is liabilities in respect of segregated funds. The actuary makes three computations with respect to National Life's liability under an UltraFlex policy in respect of the variable investments held in its segregated funds:

  • the account balances of the segregated funds in respect of the policy;
  • the present value of future commissions, investment expenses and administrative expenses, less the present value of future management fees and surrender charges, in respect of the segregated funds; and
  • the present value of liabilities in respect of the minimum death and maturity benefit guarantees in respect of the segregated funds.

In the years in issue, the present value of future investment management fees, commissions and administrative expenses was less than the present value of future management fees and surrender charges. Thus, the second computation above resulted in a negative amount. The actuarial liability or policy reserve for an UltraFlex policy that has investments in the company's segregated funds is thereby decreased by this negative number.

In determining the "A" amount as mandated by paragraph 1406(b) of the Regulations, National Life excluded the total liability under the UltraFlex policies in respect of the segregated funds, except for the third computation in respect of the minimum death and maturity benefit guarantees. This was not excluded because of the bracketed exception in 1406(b) regarding a liability in respect of a guarantee. The Minister disagreed and reassessed on the basis that the second computation was not covered by the mandated exclusion in 1406(b), leaving only the segregated account balances excluded. Including the negative amount in the second computation in the calculation of the "A" amount thereby reduced the amount of the policy reserve deduction that National Life could claim by $7,922,000 in 1997 and $15,770,000 in 1998 and increased its taxable income in those years by $7,922,000 and $7,848,000 respectively. National Life appealed successfully to the Tax Court of Canada. Justice Hershfield looked at the individual components of the liability calculation and found that the negative amount was not itself a liability but was excluded by reason of paragraph 1406(b) because it was calculated "with reference to" liabilities in respect of the segregated funds. The Crown appealed to the Federal Court of Appeal. The Federal Court of Appeal dismissed the appeal (except to correct a numerical mistake made by the Tax Court judge, on which the parties agreed).

The Decision

The issue before the Federal Court of Appeal was the calculation of the amount of the deduction that National Life was entitled to claim as a policy reserve under the Act in respect of its UltraFlex policies and, specifically, the application of paragraph 1406(b) of the Regulations in that calculation.

While agreeing with Justice Hershfield's finding that the negative amount was calculated with reference to liabilities in respect of the segregated funds, the main thrust of National Life's position was that subsection 1404(3) of the Regulations focused on the single amount that was the actuarial liability reported to the Superintendent and that it was that amount that was to be modified by paragraph 1406(b) to arrive at the "A" amount. The part of this liability that was in respect of its segregated funds would be excluded in full in computing the "A" amount under subsection 1404(3), but for the parenthetical exception in paragraph 1406(b) of the Regulations. Further, the only part of that liability not excluded in computing the "A" amount because of the parenthetical exception in paragraph 1406(b) is the part of its liability that is in respect of the minimum death and maturity benefit guarantees in respect of the segregated funds.

Justice Ryer, in writing for the Court, agreed. Although he suggests that the parties focused more on the inclusion or exclusion of the three subcomponents of the calculation, this was, in fact, not National Life's primary approach but only a response to the Crown's isolation and dissection of the second component, to support the argument that the resulting negative amount was not a liability but, rather, future profits.

In its analysis, the Court first noted that the starting point in determining the "A" amount in respect of the UltraFlex policies is the determination of the reported reserves and the policy liabilities in respect of those policies for the taxation years in question. It correctly found that this "has essentially been left to the actuarial profession, having regard to the definitions of Reported Reserves and Policy Liabilities, which underpin the determination of the component A amount." Once these are determined, those amounts must be adjusted under paragraph 1406(b) of the Regulations. In this context, the term "liability" in paragraph 1406(b) should be given a meaning that is consistent with the actuarial interpretation of that term, and therefore should be interpreted to mean a liability as determined under actuarial principles. This is important, since the actuary has determined the liability as set out above, making a number of computations to arrive at the liability including the second computation relating to its segregated funds, which the Crown sought to isolate and dissect without regard to the actuarial calculation of the liability.

The next step in the analysis by the Court was to consider why the Regulations mandated this modification to the actuarially determined reserve. Justice Ryer noted that the broad purpose of paragraph 1406(b) is to reconcile the different regulatory and income tax treatments of life insurers in respect of their obligations to make variable benefit payments under segregated fund policies.

Segregated fund policies are defined in subparagraph 138.1(1)(a) of the Act and the Court stated that for income tax purposes, such policies "are considered to be so fundamentally different from other life insurance policies that they are governed by specific rules" contained in section 138.1. The key provisions are the deemed creation of an inter vivos trust to which belongs all the property in the segregated fund and all the income generated by that property and of which the life insurer is the deemed trustee. These and the related provisions set the segregated funds apart from other types of insurance policies for tax purposes: the premiums are not required to be included in the income of the life insurer in the year of receipt and the benefits that vary with the fair market value of the property in the segregated funds are not deductible in computing its income for the year of payment.

National Life noted in its submissions that while the segregated funds are not legally separate entities from the company, the scheme of the Act reflected in these provisions is that any property allocated to a segregated fund, any income from such property and any obligation to pay benefits determined by the value of such property is not property, income or an obligation of the insurer, and, in effect, the insurer wears two hats: one as insurer and the other as deemed trustee of the segregated fund. Consistent with this scheme, National Life stated that the obligations and expense liabilities of National Life in respect of the segregated funds should be considered to be obligations and liabilities of National Life as the deemed trustee of the segregated funds (and not as insurer). The obligation under the minimum guarantee benefit is to pay amounts in excess of the fair market value of the segregated funds. There is, therefore, no property in the segregated funds to support this liability and it should therefore be considered an obligation of National Life as insurer, not as the deemed trustee.

Consistent with this analysis, the Court, in considering the purpose of paragraph 1406(b), noted that, while the obligation to make the variable benefit payment is for regulatory and legal purposes an obligation of the life insurer, for tax purposes the obligation is deemed to be an obligation of the trust. As such, the life insurer should not be allowed to claim a reserve in respect of this obligation. However, the obligation to make the minimum guarantee benefit payment does rest with the life insurer and thus a reserve ought to be allowed.

Using the actuarially determined liability of the life insurer as the starting point, paragraph 1406(b) mandates a reduction from the reported reserve of an amount equal to the actuarially determined liability of the life insurer in respect of its obligation to make variable benefit payments. Paragraph 1406(b) excludes only the amount determined to be the actuarial liability of the life insurer in respect of the obligation to make minimum guaranteed benefit payments. This has already been determined by the actuary (the third component in the segregated fund calculation) so it is simply subtracted from the total calculated by the actuary.

The Court concluded that, as a result, the negative amount that was in issue may be considered to relate to the obligation of National Life to make variable benefit payments. Finally, the Court rejected the Crown's alternative argument that the negative amount relates to the obligations of the taxpayer for minimum guaranteed benefit payments. While this was not the case for the UltraFlex policies in issue on the appeal, the Court noted that not all segregated fund policies have such a guarantee, yet the actuarially determined policy reserves reported to the Superintendent would nevertheless contain the expense/revenue computation. It cannot, therefore, relate to the guarantee obligation but, rather, relates to the obligation to make variable benefit payments. This was just one further support for the conclusion already arrived at through the Court's analysis of the meaning of "liability" in, and the purpose of, paragraph 1406(b).

Any further appeal by the Crown will require leave to appeal to the Supreme Court of Canada. The Crown has sixty days from the date of this judgment to serve a Notice of Application for Leave to Appeal.

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