Is My Policy Loan Over My ACB?

A statement arrives. One line shows a policy loan of 70,000. The line below shows an adjusted cost basis of 50,000. The loan is bigger than the basis, and you remember hearing that a loan above the basis is taxable. It is a fair moment to worry. Before you do, look at how those two numbers are built, because the answer is on the statement itself.

The adjusted cost basis (ACB) is the tax cost of your interest in the policy, a running figure the insurer keeps under the Income Tax Act. What follows is general information from a licensed insurance professional about how the federal rules work, with worked examples you can check. The figures for your own contract come from your insurer, and the treatment on your return is for your accountant to confirm. That holds for every section below, so it is said once, here.

Does a loan balance higher than my ACB mean I owe tax?

Not by itself. Each policy loan is tested against the ACB as it stood immediately before that loan, and each loan then comes off the ACB. So the ACB on your statement already has your earlier loans taken out of it. Setting it beside your loan balance takes the same loans off a second time.

The rule you remember is real. Under the Income Tax Act, a policy loan is a disposition of part of your interest in the policy. A disposition, in tax terms, is an event the Act treats as giving up some of that interest in exchange for money: a surrender is one, and an advance from the insurer is another (subsection 148(9), definition of "disposition", paragraph (b)). Subsection 148(1) then includes in your income the amount by which the proceeds of a disposition exceed the ACB immediately before it.

What gets lost is the second half of the same rule. The moment a loan is measured, its proceeds are subtracted from the ACB. The ACB on your next statement is what was left after that subtraction. It is not the figure the loan was measured against, and it is not a separate limit that your total loan balance has to stay under.

So the useful question is narrower than it first looks. Is the ACB shown today, after your loans, above zero? If it is, there is still room before the next advance produces income, up to that figure. If it is zero, the next dollar you borrow is measured against nothing. Whether an earlier loan was ever taxed is a separate question, and the insurer's records answer it, not a comparison of two lines on a statement.

What is the correct test, one loan at a time?

Take each advance on its own date and ask three things: what the ACB was immediately before it, what the proceeds of the loan were, and whether the proceeds were larger. Only the excess, if there is one, is income, and only for the year of that loan.

1. Find the ACB immediately before the loan. It already reflects every earlier loan, repayment, premium and yearly insurance charge.
2. Find the proceeds of the loan. Subsection 148(9) sets them at the lesser of the amount advanced (leaving out any part applied at once to pay a premium under the policy's terms) and the amount by which the cash surrender value immediately before the loan exceeds the balance of earlier policy loans still outstanding.
3. Compare. If the proceeds are at or below the ACB, nothing is included in income. If they are above it, the excess is included for that year under subsection 148(1).
4. Adjust the ACB. The proceeds come off, and any amount included in income goes back on, so after a loan that crossed the line the ACB stands at zero.

Two points about step 2 are worth reading slowly. The ceiling limits the proceeds to the room left in the cash surrender value. It caps the amount measured; it exempts nothing. A new advance used to pay off an old loan is still a new advance, measured against the ACB immediately before it, and the repayment it pays for is a repayment, with its own effect on the ACB. The premium exclusion is narrow as well: it covers a loan applied immediately to a premium under the contract's own terms, not cash you take and use for a premium later.

How does the test work across two loans and a repayment?

Illustrative example, with every assumption stated so you can check each line. The ACB is 40,000 before any loan. No premium is paid, no insurance charge comes off and no interest accrues between the steps, so only the loans and the repayment move the figures. The cash surrender value always leaves room for the full advance, so the proceeds equal each advance. The insurer applies your repayment to the second loan. Real figures would include all of the movements left out here, and the insurer's calculation governs.

Now read the table the way your statements would show it. After step 1, the statement shows a loan balance of 30,000 and an ACB of 10,000. The loan is 20,000 higher than the ACB, and nothing is taxable. After step 2, it shows 55,000 against an ACB of zero. Comparing those totals would suggest you are 55,000 over the line. The real inclusion was 15,000, for year 3, from the second loan alone. After step 3, it shows 30,000 against 10,000 again, the same picture as after step 1.

The 15,000 is an amount added to your income for year 3, taxed together with the rest of your income at your own rates. It is not a tax bill of 15,000. The deduction in year 5 works the same way in reverse: it lowers your taxable income for year 5, at year 5's rates, under paragraph 60(s). It is not a refund of the tax paid for year 3, and the two years can come out differently. The ACB figure after step 3 is our reading of the definition, which adds back a repayment up to the part of that loan not included in income; it is a reading, not a ruling, and the insurer's figure is the one that counts.

One assumption deserves its own question. When several loans are outstanding, how a repayment is matched to them decides whether it gives a deduction or simply rebuilds the ACB. Ask how your insurer records repayments, and ask for the ACB after each one in writing.

Why does comparing the total with the ACB count the loans twice?

Because both numbers already contain the loans. The loan balance is what you have borrowed plus any interest added to it. The ACB after the loans is what remained once those same loans were subtracted. Take the loan balance away from that ACB and each borrowed dollar comes off twice.

Illustrative example, the statement from the top. Suppose the ACB was 120,000 before you borrowed anything, and you then took several loans totalling 70,000, none of them larger than the ACB standing on its date. After the loans, the insurer reports an ACB of 50,000, which is 120,000 less 70,000. To keep it simple, this ignores premiums, interest and the yearly insurance charge, all of which would move the 50,000 in real figures.

Your statement shows a loan of 70,000 against an ACB of 50,000, and nothing is taxable. The 70,000 was already measured against the 120,000, and the 50,000 is what remains. If you subtract 70,000 from 50,000 and decide you are 20,000 over, you have taken the 70,000 off twice.

The same figures show where the real line sits today. A further advance of up to 50,000 would be covered by the remaining ACB. A further advance of 60,000 would go 10,000 beyond it, and that 10,000 would be income for the year of the advance. The line moves each time you borrow, repay or pay a premium, and each year with the insurance charge. A current figure, dated and in writing, is worth more than any figure you remember.

Where do you find the ACB, and why only the insurer can give it?

Some annual statements print the ACB and some do not. Either way, ask the insurer for it in writing, as of a stated date, whenever a decision depends on it. A printed figure can be out of date the day after a loan, a repayment or a premium.

You cannot reliably rebuild the figure from your own records. It needs every premium, every loan, every repayment, every amount already included in income and a yearly insurance charge that only the insurer calculates. The insurer keeps that running total for tax reporting, and it is the only party holding every piece. The elements are described in the glossary entry on the adjusted cost basis; the number itself comes from the insurer.

Ask for the cash surrender value and the loan balance on the same date as the ACB. The cash surrender value is what the insurer would pay if you ended the contract, and it sets how much the insurer will advance. The ACB is the tax cost, and it decides whether an advance produces income. They move for different reasons, so you need both.

What moves the ACB up and down?

The ACB is not a one-way slide to zero. It is a running total of additions and subtractions, defined in subsection 148(9), and several things you do can raise it again after a loan has lowered it.

The net cost of pure insurance is the tax rules' measure of what the insurance protection cost for the year. The insurer calculates it by a method the Income Tax Regulations prescribe: a probability of death for the year applied to the amount at risk, which is roughly what the policy would pay at death less the value built up inside it. So it does not simply rise with age. Age pushes it up; a growing cash value, which shrinks the amount at risk, pulls it the other way. The regulations also prescribe different methods depending on when the policy was issued, and the ACB definition takes this charge off only for a policy acquired after 1 December 1982.

On a contract that has stopped receiving premiums, the additions can stop while the yearly charge continues, so the ACB can drift down year after year. It can still rise again when you repay a loan, pay loan interest in cash that you do not deduct, or pay a further premium. Policy dividends are not guaranteed; the insurer's board decides them each year, and only a dividend paid to you in cash lowers the ACB in the way the table shows.

When does a policy loan really create income?

When the proceeds of that loan exceed the ACB immediately before it. The excess is income for that year, taxed as ordinary income rather than as a capital gain. It belongs to the policyholder: if a corporation owns the policy, the income is the corporation's.

Three situations bring that point closer than people expect.

• A contract that has stopped receiving premiums. The yearly charge can keep coming off while nothing goes on, so an older paid-up contract with a large cash value may have a small ACB, and a loan against it may produce income from its first dollar.
• A series of loans over several years. Each one takes its own bite out of the ACB. A contract that covered the first advance comfortably may not cover the fourth.
• Interest added to the loan instead of paid. Under the CRA interpretation described in the next section, capitalised interest is itself a further policy loan, measured like any other.

If you are unsure whether a loan crossed the line, do not work it out from the statement. Ask the insurer in writing for its calculation: the ACB immediately before each loan, the proceeds of each loan, any amount it reported as income and the year, and the ACB after. A tax slip shows that income was reported for a year. It does not show the working, and your accountant needs the working to check the slip and to plan a repayment. The full rule, including how a repayment gives a deduction later, is set out in when a policy loan becomes taxable.

What happens to the interest you do not pay?

Depending on the contract, unpaid interest is added to the loan balance on the policy anniversary or on another date the contract sets, and from then on it bears interest too. The insurer sets the loan interest rate and can change it on the terms the contract allows, so the cost of carrying the balance can move. The interest is owed to the insurer and paid to the insurer.

The tax side comes from a Canada Revenue Agency technical interpretation dated 31 May 2017, file 2016-0658641E5. In it, the CRA described interest added to the balance as a further policy loan, and so as a disposition. Where the interest is not deductible, the CRA treated the capitalised amount as a premium paid by that loan, which on its reading left nothing to include in income and no net change to the ACB. Where the capitalised interest is being deducted, the CRA treated the amount capitalised as a policy loan like any other: it produces income only to the extent it exceeds the ACB at that moment, and the CRA's example of full inclusion assumed the ACB was already nil. A technical interpretation is the CRA's view on the facts it was given at that date. It is not law, and it may not reflect the CRA's current position.

Paying the interest in cash, before the date it would be added, keeps these questions away. It stops the balance from compounding, keeps the calculation simple and, when you do not deduct the interest, raises the ACB, because interest paid counts as a premium. Find the date in your contract or on your statement and put it in your calendar the way you would a property tax instalment. The larger the balance grows against the cash surrender value, the less room the contract has left, and the closer it comes to the point described below where it can end.

Can you deduct the interest you pay?

Only when the borrowed money is used to earn income from a business or from property, and only for interest the insurer verifies. Otherwise, interest you pay counts as a premium and adds to the ACB.

The deduction comes from paragraph 20(1)(c) of the Income Tax Act, which allows interest on borrowed money used for the purpose of earning income from a business or property. The test looks at what the money was used for, not at the label on the loan. The same paragraph excludes borrowed money used to acquire a life insurance policy. Money used to buy equipment for your business or to acquire a rental property may qualify. Money used for a family trip or a personal debt does not. If the money went partly to the business and partly to personal use, only the business part can qualify, which is why a record of where each dollar went matters.

For a policy loan, the CRA asks for the insurer's verification on Form T2210, Verification of Policy Loan Interest by the Insurer. Its guidance on Line 8710, Interest and bank charges asks for that verification before June 15 of the following year for business use, and its guidance on Line 22100 points to the same form for a policy loan made to earn income. On the form, the insurer confirms the interest paid and that it will not be added to the ACB, because the same dollar cannot both raise the tax cost of the policy and be deducted. The step-by-step timetable is on the policy loans page.

Only interest you actually pay can be verified and claimed. Interest added to the loan is, on the CRA letter's reading, a further loan, and deducting it can bring an income inclusion, to the extent the capitalised amount exceeds the ACB at that moment, as described above. A deduction lowers the after-tax cost of the interest. It does not make the loan free, and the interest is still paid to the insurer.

If you live in Quebec, the federal rules above apply to your federal return, and you also report under Quebec's Taxation Act on your Quebec return. Ask your accountant to check the loan, any amount included in income and any interest claimed on both returns.

What happens to the tax when the policy ends?

It depends on how it ends. With a loan outstanding, four cases matter.

Whether a policy is exempt is decided by a test the insurer applies under the regulations, explained in the exempt test and what happens when a contract fails it. Lapse is where a loan can do the most damage, because the income can arrive in a year when no cash does. If the balance is getting close to the cash surrender value, act while the policy is still in force: pay the interest, repay part of the loan, or ask the insurer in writing what the contract offers. Reinstatement conditions are covered on the insurance premium page.

Should you replace the policy loan with a loan from another lender?

It can make sense, and while your ACB is above zero there is no tax deadline forcing the choice. Compare the rate, the repayment terms, the security each lender wants and what happens at death, and take the time to get terms that fit your cash flow.

The two are different debts. A policy loan is advanced by the insurer under the contract: you owe the insurer, and the interest is paid to the insurer. A collateral loan comes from a lender such as a bank, secured by an assignment of the policy: you owe that lender, the lender sets its own rate and conditions, and the interest is paid to the lender. An assignment of the policy as security for a debt other than a policy loan is not a disposition (s. 148(9), "disposition" (f)), so taking the collateral loan does not by itself lower the ACB or produce income.

Using the new loan to repay the policy loan has its own effects. The repayment rebuilds the ACB by the part of the policy loan never included in income, and gives a deduction under paragraph 60(s) for any part that was, as the worked table shows. Interest on the new loan is deductible only on the same use test, and your accountant will want to trace the money to its income-earning use. The lender may review the loan or call it on the terms of its agreement, and at death it is paid from the proceeds under the assignment before the beneficiary receives the rest. Some people value the policy loan's lack of a fixed repayment schedule more than a lower rate; others want the discipline a schedule brings. The comparison is set out in full at a policy advance and other credit.

What should you ask your insurer before you borrow again?

Ask in writing, with every figure as of the same date, so they can be read together. This is the one-screen list.

• The ACB today, dated, after all loans, repayments and the latest insurance charge.
• The advance you are considering, and the proceeds it would produce under the Act's definition, set against that ACB.
• The loan balance and the interest accrued but not yet added, on the same date.
• The cash surrender value, and the maximum advance the insurer will make against it.
• The loan interest rate, how the insurer sets it, and how and when it can change.
• Whether interest will be paid or added to the loan, and the date each year it would be added.
• The effect of the total balance on the death benefit.
• Whether anyone's consent is needed, such as an irrevocable beneficiary or a lender holding an assignment of the policy.
• The balance at which the contract could lapse, and what notice the contract says the insurer gives.
• Any amount the insurer has ever reported as income on the contract, the year, and its written calculation.
• Form T2210 for any year in which you paid interest on money used to earn business or property income.

Take the answers to your accountant with the insurer's written calculations, not only the slips. The contractual terms of any policy are those of the issuing insurer, and the figures that decide your case are in its records. With those figures on one sheet, the statement that worried you becomes a set of numbers you can check.

Who is this not for?

It is for someone who already has a policy loan and wants to read the statement correctly. It is not a reason to borrow, and a policy loan is not the right tool for every need.

If your contract is old and paid up, with an ACB near zero, a new loan may be income from its first dollar, and the numbers deserve a conversation before you borrow. If paying the interest each year would strain you, a balance that keeps growing puts the contract itself at risk, and another source of money may serve you better. And if your statement shows an ACB of zero, the reassurance above does not carry over: ask for the insurer's calculation before you take anything further.

If you would like to go through your own statement together, bring it to your annual review or book a conversation when it suits you. There is no rush. Knowing what the two numbers mean is the first step, and you have taken it.