Tag: Credit/debt

A policy loan and capitalized interest may be taxable, as well as a debt to the insurer

At issue

Life insurance is almost always tax-free on death of the life insured. While that person is living and where the insurance is primarily designed to fund a death benefit, the policyholder still has no income tax concerns.

Where a policy has investment and savings features, the policyholder can be exposed to tax. Accessing a policy’s cash surrender value by way of a withdrawal will be a partial disposition, a portion of which will be taxable if the cash surrender value (CSV) exceeds the adjusted cost basis (ACB) at the time.

By comparison, generally no tax applies on a policy loan up to the ACB, but any amount over that would be taxable. And when a policy loan is used to investment outside the policy, there can be not-so-favourable tax implications. This was outlined in a CRA letter from mid-2017 in response to a taxpayer inquiry initiated about a year earlier.

Income Tax Act ss.20(1)(c) & (d), s.148(9) and Income Tax Regulation s.308

ITA ss.20(1)(c) & (d) allow a deduction for interest (simple and compound, respectively), where borrowed funds are used to gain or produce income. The relevance of this will become clear in the following discussion of the CRA letter.

There are numerous sections of our tax legislation and regulations that are networked together to address the complexity of life insurance. At the heart of it is s.148(9), and the many definitions contained therein, including what constitutes a disposition of a policy, how to calculate the proceeds on a disposition, and how to determine the portion of the disposition that is taxable.

As discussed in brief above, the determination of taxability depends on a policy’s ACB, also defined under s.148(9). The key components of ACB are paid premiums that increase it, and the annual charge of net cost of pure insurance (NCPI, as defined in ITR s.308) that reduce it. Importantly, taking a policy loan decreases ACB, whereas repaying the loan generally increases ACB.

CRA 2016-0658641E5 – What are the tax implications of capitalized loan interest?)

A policyholder contacted the CRA with concerns about the fairness of the tax treatment of life insurance. The policyholder’s loans and accrued interest comprised a debt owed to the insurer that will be deducted from any payout on the policy if still unrepaid at death. Even so, the policyholder received a T5 tax slip reporting taxable policy gains related to the policy loan.

The CRA representative outlined the key definitions in s.148(9) and elsewhere before turning to the details of this particular policy loan. The borrowed money was invested for the purpose of generating income, and the policyholder/taxpayer claimed the interest as a deduction pursuant to ITA s.20(1)(c) and/or (d). Furthermore, interest on the loan was not being paid by the policyholder directly; rather the interest was being capitalized within the policy.

The writer confirmed that the combination of claiming the interest deduction and capitalizing the interest resulted in a disposition pursuant to the definition of that term in s.148(9). In turn, the ACB must have been reduced to nil in the course of these dealings, as the disposition was confirmed as taxable.

Practice points
  1. Life insurance generally accumulates tax-free, and pays out tax-free.
  2. A policyholder is more likely to face tax on a withdrawal than a policy loan.
  3. Sometimes a policy loan can result in tax, even though interest must be paid to the insurer and the loan amount reduces the death benefit.
  4. In a closing point in the 2017 CRA letter, the writer noted that many rules have been modified for policies issued after 2016. Check with your insurer how this may affect your policy dealings.

Your tax refund pre-funding an RRSP tax bill

And nine more smart things you can do with your refund

Whether it arrives by mailbox or inbox, a tax refund can feel like “found money.” But alas, it’s not; it’s basically an overpayment of tax that the government eventually gives back to you – at a zero rate of return.

For many of us, it’s the result of payroll taxes being withheld during the year based on assumed annual income. The full picture only becomes clear once your tax return is filed and all credits and deductions are fully accounted for.

When the refund does arrive, what you do with it can have significant long-term implications. Contributing at least some of it to a registered retirement savings plan (RRSP) could be a way to systematically pre-pay future tax on the plan. Here are the numbers to illustrate that strategy and a few more tax-savvy options to consider.

1. Grossing-up your RRSP

The apparent simplicity of RRSP arithmetic can be deceptive. For a person at a 40% marginal tax rate, a $1,000 contribution will generate a $400 refund. But that is literally only half the story, as the eventual drawdown will be taxable, netting right back to $600 spendable. Some savers may be quite content with that, knowing that in the meanwhile growth will be enhanced by the tax-deferred nature of a registered account.

On the other hand, some of that future tax liability could be pre-funded by contributing the refund back into an RRSP. To give full effect to this, each successive refund ($400 + $160 + $64 + …) would have to be similarly applied. In truth, this is simply an increase to annual savings but with a specific purpose in mind. Leaving aside investment returns, this would build the principal towards $1,667 in this example, which nets to $1,000 spendable. 

Now obviously a person’s tax bracket can vary over time, with the key expectation of being in a lower bracket in retirement. Rather than being a drawback to a pre-funding strategy, it makes even greater use of tax breaks in high-bracket years to fund future low-bracket retirement-income years.

Given that tax refunds are themselves tax-free, there is no drain on future income, so the process can effectively be self-funding. It takes some discipline, but ideally a conscientious savings habit and a tax pre-funding strategy could operate in concert on an ongoing basis.

Reduced withholding at source

For some, a refund may instead be viewed as cash that had been needed for current expenses, but was trapped in the tax system. If that’s so, an alternative is to file Canada Revenue Agency Form T-1213 to reduce tax deductions at source. In our example, this would have released the $400 as cash flow during the year, though the net RRSP contribution is left at $1,000. 

Alternatively, if the household budget can bear it, the pre-funding strategy could be coordinated with Form T-1213. In our example, the RRSP contribution would need to be $1,667 presently, as opposed to building in that direction over the years. 

2. Spousal RRSP

A spousal RRSP builds on the use of an RRSP to arbitrage from high to low tax brackets across time by also doing so across taxpayers – to a spouse expected to be at a lower future tax bracket. 

3. Pay down discretionary non-deductible debt

Regardless why it’s there, this kind of debt can often compound against us faster than we can accumulate savings. Eliminate such costly commitments as soon as is manageable.

4. Retire RRSP loan in the current year 

An RRSP loan can help get money into an RRSP, but if not paid off in the current year, it puts a strain on future years’ living expenses and savings. As well, the interest is non-deductible.

5. Mortgage reduction

Importantly, a mortgage funds future housing, but principal and interest are non-deductible. Retiring a mortgage allows more of a monthly budget to be devoted to retirement savings. 

6. Tax-free savings account (TFSA)

Funded out of after-tax money, the TFSA allows tax-free growth and tax-free withdrawals. The annual allotment of TFSA room for 2016 is $5,500.

7. Registered educations savings plan (RESP)

An RESP boosts education saving through income splitting, tax sheltering and government grants of up to 20% federally, with some provinces offering further financial support.   

8. Registered disability savings plan (RDSP)

Families with disability issues can face large financial challenges. The RDSP enables income splitting, tax sheltering, free government bonds and up to 300% in matching grants.

9. Non-registered investments

Registered savings form the core of retirement savings. Projected spending patterns may show a need to supplement that, and investing a refund can get that part of a plan underway.

10. Live it up … a bit

After all, saving is just spending-in-waiting – but it’s a good idea to try to keep it in balance.

Denied tax credit for interest on student loans

At issue

As many a parent will attest, it can be very costly to put a child through post-secondary schooling.  If the family does not have immediate resources available, it is common to consider borrowing to finance the need.

Fortunately, the tax system provides support to qualified loans through a non-refundable tax credit based on the amount of interest paid in the course of retiring such loans.  To qualify, section 118.62 of the Income Tax Act (ITA) requires that the loan must be made “under the Canada Student Loans Act, the Canada Student Financial Assistance Act or a law of a province governing the granting of financial assistance to students at the post-secondary school level.” 

Unfortunately, it’s almost an annual ritual that a case is reported where a past student is denied entitlement to the tax credit because the particular loan does not meet this criterion.

Mueller v. R., 2013 TCC 3

Two sisters were unable to obtain student loans under the federal government’s student loan programs, as their parents’ income was too high.  Instead, they secured loans from a bank under its “Student Line of Credit” program, promoted by the bank as being at rates lower than under the student loan program.

On filing their tax returns in the year following graduation, their interest claims related to loan retirement were denied.  

The sisters’ mother represented them in their appeals, and testified that a bank employee had represented that the loans were tax deductible.  No reference to this effect appears in the promotional literature, and no one from the bank was called to testify.

It was acknowledged that the loans were not of the listed types in ITA 118.62, which the judge found was “fatal to their claim.”  Appeals denied.

Sandhu v. R., 2010 TCC 223

The taxpayer was represented by his father in this appeal from a denied tax credit claim based on repayment of a loan to a bank.

The father provided a letter from a bank representative dated a week prior to the hearing.  It read in part: “Due to my busy schedule, I will not be able to appear personally on April 7, 2010. The student loan to Gurdarshan Sandhu was made under the Canada Student Loan program.”

The judge allowed no evidential weight to the letter as no details of the loan were provided.  Indeed, there was no way to be certain whether the referenced loan was even the loan at issue in court.  The judge went so far as to speculate whether the writer may have been confusing student loans with some internal lending program the bank makes available for professional graduate programs.  Appeal denied

2001-0074215E Refinancing-Student Loans

A taxpayer proposed to obtain a mortgage against his residence to reduce the interest rate on his existing qualified student loan.  The Canada Revenue Agency (CRA) stated that interest on the new loan would not qualify for claiming the tax credit under ITA 118.62.

2010-0376461I7E Credit for Interest on Student Loan

The CRA was asked its opinion on whether interest paid on a student loan assigned to a collections agency would still qualify for the tax credit claim.  The writer opined that the likelihood is that being under a collections process alone would not be sufficient to lose the tax credit claim, but that a court judgment would definitely extinguish it.

Practice points

  1. A ‘loan to a student’ is not necessarily a “student loan” for the purpose of claiming the tax credit on the interest.  To qualify, the loan must be arranged under the Canada Student Loans Act, the Canada Student Financial Assistance Act or a corresponding law of a province.  
  2. If challenging a denial of interest, make sure the facts are satisfied (so you don’t waste your time), and that you have the original documentary evidence to prove it.  Second and third degree-removed hearsay assertions will not suffice.
  3. A debtor should carefully consider the lost tax credit on qualifying student loans before including those debts in a refinancing or consolidation, even if on the face of it the new interest rate appears lower.
  4. A person facing collections action should understand the importance of keeping up payments on student loans in order to preserve the tax credit entitlement, as this will be lost if a judgment is entered.