Introduction: Business Deductions for Life-Insurance Costs
When computing taxable income, a taxpayer may deduct business expenses, such as interest on a loan that financed, say, a purchase of inventory. Most personal expenses, on the other hand, are non-deductible.
Yet many legitimate business expenses exhibit a personal-expense dimension, and it's often difficult to draw a bright line between the two. To this end, Canada's Income Tax Act contains various rules that aim to recognize only the business portion of a hybrid expense.
This article discusses one such rule: paragraph 20(1)(e.2), which covers the deduction for life-insurance premiums. Before reviewing the rule itself, we provide some background by discussing income-tax deductions for business expenses and collateral in the form of life insurance. The final section of this article offers tax tips for those who may have erroneously claimed prohibited life-insurance deductions.
Income-Tax Deductions for Business Expenses
Under subsection 9(1) of the Canadian Income Tax Act, a taxpayer's income from business consists of that taxpayer's business profit. So, the general rule is that, because they reduce the taxpayer's business profit, business expenses—employee salaries, advertising, interest on business-related loans, etc.—are deductible from a taxpayer's business income.
Subsection 18(1) of the Income Tax Act sets out various prohibitions on deductible expenses. In particular, paragraph 18(1)(a) requires that income deductions be attributed to a particular business or property source, and paragraph 18(1)(h) specifically disallows the deduction of personal or living expenses of the taxpayer. (Paragraph 18(1)(h) does, however, clarify that business-related travel expenses remain deductible.) In addition, section 67 provides a mechanism to reduce or eliminate an unreasonable expense.
Paragraph 18(1)(a) of the Income Tax Act makes clear that an expense's purpose—not its effect—determines whether that expense is deductible: The paragraph prohibits the deduction of an expense "except to the extent that it was made or incurred by the taxpayer for the purposes of gaining or producing income from business... ." In other words, an expense incurred for the purpose of earning income from a business is deductible even if it results in a loss.
Subsection 20(1), however, anticipates and permits various business deductions that subsection 18(1) might otherwise preclude. For instance, but for paragraph 20(1)(e.2), paragraph 18(1)(h) might outright disallow any deduction for life-insurance premiums due to the personal nature of life insurance.
Life Insurance as Collateral for a Loan & Key Person Insurance
Generally, a lender requires that a borrower put up collateral for the loan. Sometimes, the lender stipulates that the collateral be in the form of a life-insurance policy to the lender's benefit should a particular individual die.
A lender may stipulate this sort of collateral when, for instance, a single person's skill dictates the viability of the borrower's entire business. Should that person die, the viability of the borrower's entire business evaporates—along with the borrower's ability to repay the loan. This concern often arises with businesses that depend on the service of one or a few professionals—e.g., sole-practitioner or small-sized law firms, accounting firms, and medical practices.
But numerous businesses—not just those providing professional services—face the same concern. The demise of a key owner, founder, or employee might sink the entire company. To this end, insurance companies offer key-person insurance, which serves to compensate the business should a key person die or become disabled.
Deducting Premium Payments for Life Insurance Serving as Collateral: Paragraph 20(1)(e.2) of Canada's Income Tax Act
Paragraph 20(1)(e.2) of Canada's Income Tax Act permits a taxpayer to deduct life-insurance premiums from business income only if the expense satisfies three conditions:
- A "restricted financial institution" acquired an interest in a life-insurance policy in the context of a loan transaction;
- The financial institution required the borrower to assign the life-insurance interest as collateral for the loan; and
- The borrower may otherwise deduct the loan's interest from taxable income.
In short, you may deduct life-insurance premiums if a bank or similar financial institution required you to put up life insurance as collateral for a loan, and you obtained the loan to finance your business.
If, however, you voluntarily put up life insurance as collateral when this sort of collateral wasn't a condition for the loan, you cannot deduct the insurance premiums. In Norton v. The Queen, 2010 TCC 62, the Tax Court of Canada denied a taxpayer's deduction for insurance costs because the taxpayer couldn't prove that the lending institution required him to take out life insurance as collateral. Before the deduction is available for the taxpayer, the lending institution must require the insurance as collateral for the loan.
Notably, the deduction isn't available if the life insurance served as collateral on a private loan. The deduction is available only if the lender is a "restricted financial institution"—that is, a bank, a credit union, a trust company, an insurance company, and the like. Moreover, the deduction is available only if the life-insurance company is obligated to pay the insurance proceeds to the lending institution (Lloyd Quartz v. The Queen, 2002 CanLII 47038 (TCC),  1 C.T.C. 2714).
Paragraph 20(1)(e.2) also seeks to carve out the personal aspects of the premium expense by imposing a cap on the allowable deduction. So, if the policy premium qualifies for the deduction, the amount that a taxpayer may deduct is the least of three values:
- premiums actually paid;
- The "net cost of pure insurance," which is basically the premium minus any savings component that the policy may include; and
- The portion of the premium that reasonably relates to the outstanding portion of the loan.
In addition to carving out the personal aspects of the insurance cost, like any savings component, these criteria match the tax treatment of insurance costs with that of interest expenses: as the taxpayer pays down the principal, the deduction available for insurance costs, like that available for interest expenses, will decrease.
Tax Tips – Voluntary Disclosure for Unpermitted Life-Insurance Deductions & Tax Planning for the Deductibility of Life-Insurance Premiums
While many taxpayers know that the Income Tax Act permits a deduction for life-insurance premiums, some fail to understand the restrictions on this deduction. As a result, taxpayers may underreport income and thereby expose themselves to significant monetary penalties if they fully deduct life-insurance costs when:
- The lender isn't a bank or similar financial institution;
- The lender didn't require life insurance as collateral for the loan;
- The loan wasn't for a business purpose;
- The deducted insurance cost includes amounts from the policy's savings plan; or
- The deducted insurance cost doesn't account for repayment of the loan's principal.
If you deducted life-insurance costs under any of these circumstances, you risk triggering the Income Tax Act's various monetary and criminal penalties.
An application under the Canada Revenue Agency's (CRA) Voluntary Disclosures Program may offer a remedy. But you lose this option if the CRA discovers your mistake beforehand.
So, speak with one of our experienced Canadian tax lawyers today. We can review your situation and discern whether you're indeed non-complaint. If so, we will carefully plan and prepare your disclosure application. A properly prepared disclosure application not only increases the odds that the CRA will accept your disclosure but also lays the groundwork for a judicial-review application to the Federal Court should the CRA unfairly deny your disclosure.
Further, two tax-planning measures may ensure that your premium deductions withstand CRA scrutiny. First, you should ensure that your loan agreement is drafted by a skilled Canadian tax lawyer, and that it clearly stipulates that your lender required the life insurance as collateral. Otherwise, you risk losing the deduction like the taxpayer in Norton. Second, you should ensure that the insurance company is obligated to pay the insurance proceeds to the lender by either naming the lender as the beneficiary of the life-insurance policy or executing an assignment contract with the same effect. If, as in the Lloyd Quartz case, a party other than the lender is entitled to receive the insurance proceeds, you cannot deduct the premium costs. In short, make sure that your loan agreement is planned and drafted by a professional Canadian tax lawyer.