An overview of CII legal status and tax treatment

Hélène Marquis, LL.L., D.Fis., Pl. Fin, TEP
Senior Planning Consultant
Wealth Protection Group
Sun Life Financial

In brief

Introduced in the 1990s, critical illness insurance (CII) is designed to provide a lump-sum payment within a contractually defined time period after the diagnosis of one of the specified conditions covered under the plan.

Because the product is relatively new, the current legal and tax environment does not specifically address this type of insurance. As a result, the various provincial insurance legislations that deal with “sickness and accident insurance” and the Canada Revenue Agency (CRA) Technical Interpretations presently govern the sales and marketing of critical illness insurance.

It’s important to be aware of CRA's current position on critical illness insurance so this product can be appropriately included in your client’s financial plan. Since critical illness insurance is in a growing category in the financial services sector, understanding the tax implications is important.

Legal status across Canada

The characterization of CII products depends on the provincial legislation applicable to such a product and may impact how it is treated for tax purposes. Fortunately, most Common Law provinces have similar insurance acts. As such, the CII products currently available on the market generally meet the provincial law requirements to be considered “sickness and accident insurance”¹ as long as the product is a stand-alone policy or a group CII insurance plan.

On the other hand, some product features, such as the refund of premiums or a critical illness rider attached to a life insurance policy, may create legal uncertainties that consequently affect the tax treatment, depending on how plans are used.

In Quebec, the Quebec Civil Code (QCC) provides for a comprehensive system applicable to the “insurance of persons” products that include an “accident and sickness” policy. It allows for beneficiary designation on any type of “insurance of persons” plan.² In addition, the QCC makes it easier to implement more complex CII sales concepts by formally indicating that secondary benefit clauses of an accident and sickness insurance contract are governed by the rules applicable to the principal contract.³

Tax considerations

CII products are not specifically covered by the current Income Tax Act (ITA). Their tax treatment is highly dependent upon their legal qualification as life insurance or as sickness and accident insurance under the provincial legislations.

Up to this point, the CRA has tended to interpret existing law as it applies to CII coverage. It has not yet seen the need to draft changes or additions to the existing ITA that directly pertain to CII.

CRA’s Technical Interpretations and opinions have no force of law and are not considered as binding by either the Finance Department or the Canada Revenue Agency. As a result, it’s important to note some considerations when financial and tax planning involves critical illness insurance – whether individual or corporate-owned policies:

No premium deductibility– Premiums paid are not tax deductible for either individually or corporate owned policies. CRA has indicated an exception can be considered for premiums paid by a corporation when a qualifying Health and Welfare Trust is in place⁴.

Tax-free payout– The product is designed to provide for a tax-free lump sum payout on diagnosis of a critical illness. CRA’s Technical Interpretations have increasingly supported this position with stand-alone CII plans. As yet, no guidelines have been issued when CII coverage is a supplementary benefit attached to a life insurance policy.

No credit to the Capital Dividend Account (CDA)– Credit to a corporation’s CDA is available only for life insurance death proceeds received by the corporation as beneficiary of the policy. Since CII qualifies as sickness and accident insurance coverage and not as a life insurance policy, the CII payout does not qualify for the CDA credit calculation⁵.

Taxable benefit to employee or shareholder– A taxable benefit to an employee⁶ or a shareholder⁷ may occur when:

• the benefits are paid to an employee directly, while the premiums are paid by the employer for individual CII coverage on the employee’s life;⁸
• the benefits are paid out directly to a shareholder, while the premiums are paid by the employer for individual CII coverage on a shareholder’s life (this means that the company cannot deduct the premium cost, resulting in double taxation on the dollars used to pay for this coverage); and
• a corporate owned CII policy is transferred to an employee or a shareholder, while the corporation pays the premiums.

Return of premiums (ROPs)- CRA has provided limited direction with regards to the legal characterization – and consequently the tax treatment – of ROPs. However, it appears that a CII policy offering a return of premiums should not give rise to taxable income if:

• both the policy and the ROP benefit qualify as a sickness and accident plan; and
• the total benefit does not exceed the actual premiums paid.⁹

Advising clients

Given today’s demographics in terms of life expectancy, incidence of disease and survival rates, critical illness insurance is an important part of your clients’ financial plan. Although there are currently no specific laws to address the product, there’s evidence that the CRA is becoming increasingly more comfortable with the product and its features.

• There is no evidence to suggest that the current tax-free status of the lump-sum benefit payout will change.
• Where complex sales concepts are involved it may be prudent to seek an Advanced Tax Ruling (ATR) from the CRA due to the current tax and legal status of critical illness insurance.

In the fall of 2004, the Canadian Life and Health Insurance Agency (CLHIA) and the Conference of Advanced Life Underwriters (CALU) submitted a recommendation on Critical Illness tax treatment to Finance. You can access a copy of the submission at: http://www.calu.com/website/publications.html

Endnotes

• CRA has already expressed concerns regarding the qualification of a CII group plan as “sickness insurance” with regards to the definition contained in the Insurance Classes Regulation in British Columbia (CRA Views 2005-0112781E5).
• Article 2445 QCC
• Article 2394 QCC
• This type of arrangement will be covered in the next issue of Advisor Notes.
• Para. 89(1)(d) ITA
• Para. 6(1)(a) ITA
• Ss. 15(1) ITA
• Ibid., footnote 4.
• he issues surrounding return of premiums will be explored in more detail in a future edition of Advisor Notes.