today we're going to talk about the material under chapter 7 in your text and this has to do with the taxation of life insurance now in my history of teaching this course I find this is the chapter that most people have difficulty with and so we're going to spend some time on this there are two or three um segments that we're going to go through but for the most part uh I think and I hope that uh going through this in a bit of detail that I'm going to do will help you understand taxation of life insurance now lots of people uh cringe when they hear the word taxation but uh the reality is it is a part of life uh and in fact uh with respect to life insurance you know we talk primarily the one of the big advantages of life insurance is that the death benefit uh is paid out to the beneficiaries taxfree and so when we say wow the death benefit is paid out tax-free why do we have a whole chapter on taxation of life insurance if the death benefit is paid taxfree well the reality is that uh while the death benefit is taxfree if in fact you decide to surrender your policy cancel it make a change to it uh and those types of activities in fact could trigger a tax liability that's why we need to spend time looking at how we calculate tax liabilities for life insurance policies in the event we surrender them or in the event we take a policy loan or we may reduce part of it so there are lots of different things and features we have on an insurance policy that we can effect that can impact the taxation of that policy so first simple one the death benefit is tax-free not a problem however if you dispose of the policy while you're alive when I say dispose of I mean you surrender the plan you cash it in however you want to say this there could be tax consequences and so when I actually surrender my policy that's deemed to be a an actual disposition I actually got rid of it I sold it or I surrendered it or I transferred it to someone else I no longer have the policy and so there are tax implications possible there there is something else called a deemed disposition where the income tax act says if you do certain things to an insurance policy we're going to treat it from a tax standpoint as if you actually sold or got rid of the policy so there are actual dispositions where I actually surrender my policy or there are certain deemed dispositions where uh I have done something to the policy to trigger a potential tax liability so let's talk about deem dispositions so a deem disposition as I said there could be a tax consequence even if there's no transfer of ownership or actual surrender of the policy let's look at those scenarios where this could be possible for example you withdraw some cash out of the plan you go and in fact instead of taking cash out you decide to take a policy loan you borrow money against your policy dividends from participating policies uh Dividends are usually taxable and so there is a tax liability in that scenario and you'll see a couple of things on the slide something called a policy becoming non-exempt I'll talk about that uh situation in a future uh segment but just uh bear it in mind I'll bring it back up uh when a policy becomes non-exempt or becomes taxable uh in addition to that a policy holder dies and you're not in other words you own a policy on somebody else's life it's an asset you actually own and that policy may have value in it if you die you deem to have sold that policy so those are certain of those scenarios that we call deemed dispositions that may or may not trigger a liability for paying income tax now let's think about IM actually going to surrender my policy in other words this is going to be an example of an actual disposition not a deemed disposition I'm actually going to surrender my policy and so when I Surrender my policy very simply uh if I get back more when I Surrender it than what I put into it then in fact I've made money and under the income tax act because you've made some money then you're going to have to pay some tax on the gain you have this is no different than let's say for example uh you decide to buy a condo that you're going to rent a rental condo and in fact you paid $300,000 for this condo and in fact you added made some improvements you put in some new flooring upgraded the kitchen and so now instead of your cost being 300,000 with those additions that you put in your cost is now 3 $25,000 so you spent an additional $25,000 to improve your condo by putting additional $25,000 in that means your original cost was $ 300,000 the additional $25,000 now means your adjusted cost is $325,000 if in the future you sell that condo for $400,000 you would have a gain of $75 ,000 because you got back more than what you put into the condo similar idea works with an insurance policy so if you were to dispose of your insurance policy cancel it and the insurance company gives you back usually your cash surrender value if that cash surrender value is more than the total premiums that you've put in you've made a gain you've got back more than you put in and then if you get back more than what you put in then you're going to have to pay tax on that gain so when we look at the formula for calculating your policy gain it's going to be your proceeds of disposition other words what you got back from the insurance company minus how much you put into the plan it's called your adjusted cost base and so your adjusted cost base is going to be based on the date that you purchase that policy in December first 1982 Revenue Canada made changes to the income tax act and they changed the formula for the adjusted cost base on an insurance policy from that date going forward and so when we see the term last acquired date in other words they're saying what is the date you actually acquired this policy and in fact did you make any changes since that date that might modify that acquired date and if you did then that could change the acquired date of the policy and therefore could change the formula that we Ed to calculate the adjusted cost base and so the acquired date of the policy can be the date the policy was purchased it could be the date that the policy was maybe purchased and then the data was transferred to someone else for example I might have had a business partner we're no longer in business I own the policy on her life we're no longer in business I no longer need that policy I will transfer the ownership to her the acquired date of that policy for her would be the date that she got it from me she I transferred it over to her and so those are things that could change the acquired date so let's look at the adjusted cost based formula the formula for the adjusted cost base depends on the date the policy was last acquired if the last acquired date for the policy is prior to December 2nd 1982 the adjusted cost base the formula for the adjusted cost base is the total of your premiums paid for all the time you had the policy minus any dividends you might have been declared now you may recall from a previous sector participating Whole Life policies are the ones on that would have declared dividends and so if I wanted to calculate the adjusted cost base on my participating whole life policy I would have to determine what are the total number of premiums I paid in since I own the policy and subtract from that all the premiums sorry all the dividends I would have received from the company over the years I held the policy that will be my adjusted cost base if I had a term insurance policy my adjusted cost base would simply be the total premiums I paid because term policies do not pay dividends and so my total premiums paid would me be my adjusted cost base so that first Formula you see on the slide applies to policies that were purchased prior to December 2nd 1982 after December 1st 1982 when Revenue Canada changed the formula for the adjusted cost base you could see from the formula they added one other element they added something called the net cost of pure insurance and so they put a number in there but you subtracted from the total so the new formula in fact ends up with an adjusted cost base that is lower than the old formula so the adjusted cost base under the new basis premiums paid minus the dividends that were were declared minus something called the net cost of Pure Insurance now what is the net cost of Pure Insurance you may recall when we talked about universal life I had a a graph up there indicating that the cost of insurance comes out each month the net cost of Pure Insurance is actually the total of all the of of the premium dollar that was used to pay for the cost of insurance every month on your universal life policy and so that net cost of insurance the insurance company will actually provide that for the customer so the new formula after December 1st 1982 has this additional element and what that effectively does is makes the adjusted cost base lower and as a result of that that makes the client's policy gain higher so there's more taxable under the after DEC member 1st 1982 than there was before 1982 so let's take a look at an example Brian had a $200,000 whole life policy which he purchased 15 years ago in year 2003 he paid an annual premium of $2,000 per year and received a total of $4,000 in dividends he was told by the company that the policy net cost of Pure Insurance you see that term ncpi was $3,500 he surrendered the policy and received $31,000 doeses he have a policy gain in other words is there any part of the money he got back and he's going to have to pay income tax on well let's look at the formula the formula as you know policy gain is going to be the proceeds of disposition minus the adjusted cost paase so let's first take a look at the first part of that formula the proceeds of disposition what were they what did he get for the policy well we can see from the information it was $31,000 so the first part of our formula we have the number that fits under proceeds of disposition it's $31,000 let's now concentrate on the second part of the formula which is to determine the adjusted cost base of the policy now we need to make sure as we know the adjusted cost base there are two formulas one before December 2 1982 and one after December 1st 1982 so in this case the policy was purchased in 2003 therefore we have to use the newer formula and the newer formula is pro premiums paid minus dividends declared minus the net cost of Pure Insurance and so let's go back and look at the total premiums he paid he's had the policy for 15 years at 2,000 a year so he has put in $330,000 however we must take out any dividends that he got back and he received $4,000 in dividends in addition to that we need to take off the ncpi which we are told is $3500 so the policy's adjusted cost base is going to be $30,000 minus $4,000 minus $3,500 for an adjusted cost base of $22,500 so we have just calculated the second part of that formula which is $22,500 is there a policy gain well yes there is it's going to be $31,000 which were the proceeds of disposition minus 22,500 which is the adjust cost base of the policy and therefore Brian is going to have a policy gain of $88,500 this means he needs to add $88,500 to his income to his tax his earnings in the year 2003 when he surrendered the policy so he needs to pay income tax on that 8,500 because at the end of the day he got back $8500 more than the net amount that he put in