Life Insurance Deductions: A Guide for Canadian Businesses

Posted on by Tax Partners
01
Jan

Introduction

Life-insurance premiums can sometimes be deducted as business expenses, but these deductions are subject to strict rules under the Income Tax Act. Misunderstanding these rules can lead to denied claims, audits, or penalties. 

Here’s an updated guide to help you understand when and how life-insurance premiums may qualify as a business deduction.

Introduction: Business Deductions for Life Insurance Costs

When computing taxable income, a taxpayer may deduct certain business expenses that are incurred to earn income. Life-insurance premiums are one such expense, but they come with restrictions to ensure they are used appropriately for business purposes. 

This guide focuses on paragraph 20(1)(e.2) of the Income Tax Act, which governs the deduction of life-insurance premiums in specific cases.

Understanding Life Insurance in Business Contexts

Life Insurance as Collateral

Lenders often require borrowers to provide collateral for business loans. In some cases, this collateral can take the form of a life-insurance policy. For example:

  • A lender may require a life-insurance policy on a business owner whose death could jeopardize the repayment of the loan.
  • Key-person insurance is often used to protect businesses from financial losses due to the death of a critical team member, such as a founder or executive.

Deducting Life-Insurance Premiums Under Paragraph 20(1)(e.2)

Conditions for Deductibility

To claim a deduction for life-insurance premiums under paragraph 20(1)(e.2), the following conditions must be met:

  1. Restricted Financial Institution: The loan must be provided by a recognized financial institution, such as a bank, credit union, or insurance company.
  2. Collateral Requirement: The lender must specifically require the life-insurance policy as collateral for the loan.
  3. Business Purpose: The loan must be used to finance a business-related expense, and the interest on the loan must be deductible under the Income Tax Act.

Calculation of Deductible Amount

If all conditions are met, the deductible amount is the least of:

  1. Premiums actually paid.
  2. The net cost of pure insurance (excluding any savings or investment components of the policy).
  3. The portion of the premium reasonably related to the outstanding loan principal.

Common Missteps in Claiming Deductions

  1. Voluntary Use of Life Insurance: If the borrower voluntarily uses life insurance as collateral, without it being a lender requirement, the premiums are not deductible.
  2. Non-Business Loans: Deductions are only allowed if the loan serves a business purpose.
  3. Non-Qualified Lenders: The deduction is invalid if the lender is not a restricted financial institution, such as in private or informal loans.
  4. Policy Components: Only the pure insurance cost is deductible, not savings or investment portions of the premium.

Case Study Examples

  • In Norton v. The Queen (2010), the Tax Court of Canada denied the deduction because the taxpayer failed to prove that the lender required the life-insurance policy.
  • In Lloyd Quartz v. The Queen (2002), the court ruled that premiums were not deductible because the insurance proceeds were not assigned to the lender.

Key Planning Tips

  1. Clear Loan Agreements:
    • Ensure that the loan agreement explicitly states that the lender requires life insurance as collateral.
    • Work with experienced accountants to structure agreements that comply with CRA requirements.
  2. Assign Insurance Proceeds:
    • The insurance company should be obligated to pay proceeds directly to the lender, either by naming the lender as the beneficiary or via a contractual assignment.
  3. Monitor Loan Usage:
    • Keep detailed records of how loan proceeds are used to ensure they are applied toward eligible business purposes.
  4. Consult a Tax Professional:
    • Tax laws governing life-insurance deductions are complex. Seek expert guidance to ensure compliance and maximize allowable deductions.

Conclusion

Deductions for life-insurance premiums offer valuable tax relief but are subject to stringent conditions. Ensuring that the loan agreement, insurance policy, and related documentation meet CRA requirements is critical. Missteps can result in denied deductions, reassessments, or penalties. 

By working with knowledgeable accountants, businesses can properly structure their financial arrangements to claim these deductions while remaining compliant with tax laws.

This article is written for educational purposes.

Should you have any inquiries, please do not hesitate to contact us at (905) 836-8755, via email at [email protected], or by visiting our website at www.taxpartners.ca.

Tax Partners has been operational since 1981 and is recognized as one of the leading tax and accounting firms in North America. Contact us today for a FREE initial consultation appointment.

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