Deducting life insurance costs: Paragraph 20(1)(e.2) of Income Tax Act explained

Introduction

Dale Barrett and Simon Townsend of Barrett Tax Law.

The cost of life insurance is a cost which is usually borne by individuals and is not something that people think of as a deductible expense.

With numerous deductions for loss from a business (or property) available in Canada's tax legislation, it is possible if not probable that some opportunities will be missed. The opportunities that may be missed for income deductions naturally go back to some of the most technical provisions in the Income Tax Act, RSC 1985, c 1 (5th Supp.) (ITA). One of these technical provisions is examined here: paragraph 20(1)(e.2).

This provision allows a person or business to deduct the reasonable cost of life insurance, in the event it is used as collateral in a business financing agreement. When would this be useful, and why would it be missed? Moreover, what makes this provision so technical? This series seeks to answer these questions, clarifying a technical provision in the ITA starting with a relatively simple example.

When would paragraph 20(1)(e.2) be useful?

A company or one of its business units may have one or more key persons — perhaps executives or company rainmakers. A key person may be a technical person like a researcher or a chief technology officer.

What is common about these people is that their death would prove to be detrimental to the business. As such, it is commonplace for a company to buy insurance against the loss of a person who is integral to its business or who is perhaps difficult or impossible to replace. This insurance comes in the form of a life insurance policy, commonly referred to as "key person insurance."

Different from "dead peasant insurance" (insurance purchased by corporations on the lives of low- wage workers — usually without their knowledge), key person insurance is meant to mitigate the losses that would take place by a business should a key person die. It allows the business to use the payout to try to find a replacement or to give the business an opportunity to get back on track.

Aside from their direct value to the company, many key employees have a value to financial institutions which often agree to finance a company on the basis of their faith in that person and their value to the business. As part of a financial arrangement based in part on an individual's merit, credentials or experience, the lending institution may require collateral to compensate in the event something happens to that person.

Key person insurance may then be taken out by the company and used as collateral in the loan agreement, or an already existing life insurance policy may be assigned. This will protect the lending institution against something happening to the individual whose merit ensures continued loan repayment.

In such a case, paragraph 20(1)(e.2) becomes a valuable tool for the borrower. The way that it works is that this provision allows the borrower to deduct from their income, reasonable costs of a life insurance policy which in turn facilitated the financing with the lending institution.

From a tax perspective, a life insurance policy assigned to a financial institution to earn income or one which is specifically taken out to facilitate a business loan is different from a policy purchased specifically to mitigate the loss of a key person.

Since the borrowed funds are used to earn income and an interest in the life insurance has been assigned, the expense of owning life insurance has changed. Similar to any other reasonable expense used to earn income, it is deductible when reporting at the end of each tax year, but only by virtue of paragraph 20(1)(e.2) of the ITA.

In the case of pre-existing key person insurance which is then assigned it to a lender, upon the assignment, the purpose of such insurance changes from a mitigation purpose (one which protects the company from the losses which occur and the damage which occurs from the death of a key person) to an income-earning purpose.

This is part one of a two-part series. Part two will discuss why paragraph 20(1)(e.2) may be missed and what makes the provision technical.

This is part one of a two-part series. Click here to read part two.

Dale Barrett is the managing partner of Barrett Tax Law, founder of Lawyers & Lattes Legal Cafe, author of Tax Survival for Canadians and the editor of the Family Law and Tax Handbook and a columnist for The Lawyer's Daily. He is also a frequent tax lecturer, primarily for accountants. Simon Townsend is an articling student at Barrett Tax Law.

This article was originally published on the Lawyer's Daily. Image by Steve Buissinne from Pixabay.