GLOSSARY OF UNIVERSAL LIFE TERMS

Adjusted Cost basis (ACB):
The adjusted cost basis of a life insurance policy is calculated using a complex formula that takes into account all deposits into, withdrawals or loans from, dividends and the cost of insurance charges of a policy. The governing section of the Income Tax Act (Canada (ITA) section 148(9).
An oversimplified definition for the vast majority of policies, and assuming no cash withdrawals, cash dividends or loans from the policy, looks something like this:

Policies issued before Dec. 2, 1982:
Total premiums paid

Policies issued Dec. 2, 1982 or later:
Total premiums paid
Less: Net cost of pure insurance (NCPI)

ACB is increased by the total of all premiums paid and decreased by the annual NCPI. NCPI generally increases year over year to the point where it exceeds the premium or deposit, if any, being paid. For this reason, the ACB of a policy is issued and then declines to zero after a number of years. Once the ACB reaches zero, every dollar of cash withdrawn from the policy, by whatever means, will be taxable.

Canada Customs and Revenue Agency (CCRA):
This is the name of Revenue Canada since Nov. 1, 1999.

Capital Dividend Account (CDA):
The Capital Dividend Account is a notional tax account into which certain capital receipts of a corporation can be credited. It enables a corporation to pay a tax-free dividend to shareholders.

The CDA is available only to private corporations that are resident in Canada. Here are some key criteria for determining if a corporation qualifies for a CDA, although final determination of whether a corporation qualifies for a CDA rests with the client's legal, taxation and accounting advisors:

- The corporation must be a Canadian corporation, which usually means it has been incorporated under federal or provincial law after 1977.

- The corporation must be a private corporation and cannot be controlled directly or indirectly by a public corporation (see section 89(1) of the ITA).

- The corporation must receive non-taxable money, such as non-taxable portion of a capital gain less the non-deductible portion of any capital loss. The tax free portion of realized capital gains is credited to the CDA. When life insurance death benefits are received by a corporation, the mortality gain is credited to the CDA.

Any capital dividend is paid on a tax-free basis. The dividend distribution must be made on a pro-rata basis among all shareholders of the class of shares on which the dividend is declared.

Cash surrender value (CSV):
When cash value life insurance is surrendered during the life lifetime of the person whose life is insured, the cash surrender value is the amount that the policy owner receives after any outstanding policy loan, interest and other surrender charges have been paid. The CSV is a taxable income receipt to the extent that the CSV exceeds the policy's ACB.

Cash value life insurance policy or cash value policy:
Permanent life insurance can provide life insurance coverage and cash value growth within the contract. For the purpose of this guide, "cash value life insurance" and "cash value policy" refer to life insurance policies that are exempt from annual accrual taxation of the growth in cash value under the provisions of the ITA.

Collateral assignment:
In the common law provinces and territories, the owner of a life insurance policy can use the policy as collateral for a loan or line of credit. The owner cannot sell or dispose of the policy without either first getting the lender's consent or paying off the loan or line of credit. This process is sometimes called a "A partial assignment".

Income Tax Act (Canada) (ITA):
This is the Federal statute that governs taxation of the income of individuals, corporations, partnerships, trusts and estates in Canada. The provinces and territories also levy income tax. The ITA is amended on a regular basis.

Leveraging:
A policy owner assigns a life insurance policy to a financial institution as collateral for a loan or line of credit. In the common law provinces and territories, the legal mechanism is "collateral assignment". In Quebec, it is a "movable hypothec".

Mortality gain:
When an eligible corporation (see definition of CDA) receives life insurance proceeds, the mortality gain is credited to the CDA. The mortality gain is the life insurance death benefit minus the ACB of the corporation in the life insurance policy.

Movable hypothec:
In Quebec, the owner of a life insurance policy can use the policy as collateral for a loan or line of credit.

Net cost of pure insurance (NCPI):
NCPI is calculated based on a prescribed mortality charge applied to the amount at risk (i.e. the total death benefit less the accumulating fund of the policy). It is a separate calculation for tax purposes and need not have any relationship to the actual mortality charges assessed under the policy.

Policy advance or policy loan:
Cash value life insurance contracts can permit the policy owner to receive an advance against the death benefit payable under the terms of the policy. Most people (advisors and clients alike) refer to this arrangement as a policy loan and consider this to be a form of borrowing. While terms like "policy loan" and "borrow" are used to describe this method of accessing the cash value of a policy, the legal requirements and obligations of this arrangement are different from when a person uses a cash value policy as collateral for a loan or line of credit from a financial institution. Like a loan from a financial institution, interest on the advance must be paid. The policy advance is taxable to the extent that the amount borrowed exceeds the policy's ACB. For convenience, we will refer to this arrangement as a "policy loan" and will use the term "borrow" to describe the action of accessing the cash value of the insurance policy.

Policy withdrawal:
Cash value life insurance contracts can permit the policy owner to make a permanent withdrawal of part of the policy's cash value. Withdrawals result in a permanent reduction in the amount of life insurance coverage. A withdrawal is a taxable income receipt of the policy owner calculated on a pro-rated basis.

Retirement Compensation Arrangement (RCA):
A Retirement Compensation Arrangement (RCA) is an inter vivos trust (one set up during an individual's lifetime) that is used to provide retirement income or benefits to an employee. Under the ITA, 50% of all deposits to the trust must be paid to CCRA, which holds them in a refundable tax account (RTA). Once the employee begins to receive retirement income, the RCA trust may get a refund of $! from the RTA for every $2 paid to the employee. The RCA rules in the ITA permit CCRA to deem an RCA to exist when an employer is under an obligation to provide retirement income and other technical criteria are met. It is possible for CCRA to determine that an RCA exists years after the structure was set up, which can result in a significant retroactive tax liability.

Ivon T. Hughes, The Hughes Trustco Group Ltd.

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Tel: (514) 842-9001 Email: info@trustco.ca

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Articles from July 2007
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