The Exempt Test and What Happens When a Contract Fails It

The exempt test is the check that the Income Tax Regulations apply to a Canadian life insurance contract at every policy anniversary. It asks whether the value building inside your contract has stayed under a ceiling set by notional benchmark policies. A contract that stays under is an exempt policy, and its growth is not taxed each year. A contract that goes over, and is not brought back inside within 60 days, stops being exempt, and two tax events follow. On that day you are treated as having disposed of your interest for its accumulating fund, so any amount above your adjusted cost basis is income, though no cash is paid out. From then on, the growth is taxed at each anniversary.

Everything below is general information from a licensed insurance professional. The test is run by the insurer that issued your contract, on figures only it holds. Canadian Wealth Creation Centre Inc. is not authorized to give legal, tax or notarial advice and gives none here. Where I say what a section provides, that is our reading of the text published on Justice Laws, not a ruling from the Canada Revenue Agency. What a failure would cost you is a question for a Chartered Professional Accountant with the insurer's figures in hand. The short definition is in the glossary, and why growth inside an exempt contract is deferred is covered in tax deferred growth.

What does the exempt test compare?

It compares two numbers at each policy anniversary. The first is the accumulating fund of your actual contract, worked out without regard to any policy loan. The second is the total accumulating fund of one or more exemption test policies. Your contract passes when the first is not larger than the second. That comparison is paragraph 306(1)(a) of the Income Tax Regulations.

The exemption test policies are not real contracts. The Regulations deem them to be issued beside yours, with terms fixed by subsections 306(3) and 306(4). Their only job is to set the ceiling. Each one pays a level death benefit up to an endowment date the Regulations set, and is paid for over a pay period the Regulations also set. Neither you nor the insurer negotiates those terms.

The purpose is to keep a life insurance contract working as insurance first. Canadian tax law lets value build inside an exempt policy without yearly tax, and the test limits how much value the contract can hold against the benchmark for its death benefit. It is not a dollar limit written in the Act, and it is not the premium on your illustration. It is a comparison that moves as your contract and its benchmarks change.

What are the four conditions an exempt policy must meet?

The comparison is only the first of four conditions in subsection 306(1). The other three turn a one-day check into a record the contract carries for life. On our reading of them, they work like this:

The forward-looking condition depends on when your policy was issued. For a policy issued before 2017, subparagraph 306(1)(b)(i) asks whether the ceiling can reasonably be expected to hold at each anniversary on which the policy could stay in force, up to the benchmark's endowment date. For a policy issued after 2016, subparagraph 306(1)(b)(ii) looks only at the next policy anniversary. It adds two instructions: leave out any automatic adjustments the policy may make later to stay exempt, and project with the most recent values used to calculate the accumulating fund. For a participating policy, both versions assume that dividends will be paid as shown in the dividend scale.

Subsection 306(2) settles the first year: a contract that is exempt at its first anniversary is deemed exempt from its date of issue. Exempt status is therefore a tax classification. It applies at a given time to a contract that meets all four conditions. The insurer checks it; you do not apply for it. If it is lost, the tax treatment changes, while the insurance contract and its coverage carry on.

What is the accumulating fund, and why is it not on your statement?

The accumulating fund is the tax measure of the value inside a contract. It is defined in section 307 of the Income Tax Regulations. It is not the cash surrender value on your statement, and it is not the premiums you paid. For your real contract, it comes from reserve figures the insurer calculates under rules the Regulations point to, scaled to your share of the contract.

The benchmark side is calculated on assumptions set in subsection 307(2). For a policy issued before 2017, subparagraph 307(2)(c)(iii) puts a floor under the interest rate. On our reading of it, the floor is 4 percent a year for a policy issued after April 1985. For coverage under a policy issued after 2016, paragraph 307(2)(d) ties the interest and mortality assumptions to those used in the reserve calculations the Regulation names, instead of a fixed floor.

So you cannot run the test from your own paperwork. Both sides depend on calculations only the insurer performs. What you can do is ask, in writing, for the accumulating fund and the adjusted cost basis on a stated anniversary, and for the room that remained under the ceiling that day. The same letter can ask for the room projected at the next anniversary.

Three figures are easy to confuse, and each answers a different question:

What changed for policies issued after 2016?

The rules were rewritten for policies issued after 2016, and section 306 now carries both versions side by side. Your policy's deemed year of issue decides which set applies. Here are the main differences on our reading of sections 306, 307 and 310 of the Regulations today:

The Regulation does not say what these changes do to a particular design. Reading the terms, a shorter pay period lets the benchmark build value faster in its early years, and a later endowment date spreads its growth over more years. The net effect on your contract shows only in the insurer's own calculation. Ask for it by issue year and design, rather than relying on a general rule of thumb.

Subsection 148(11) of the Income Tax Act is the door between the two regimes. It deems a policy issued before 2017 to be issued after 2016 at the time term insurance under the policy is converted into permanent insurance under its terms. It does the same when life insurance medically underwritten after 2016 is added, unless the underwriting was only to obtain lower premium or cost of insurance rates. Insurance bought with policy dividends, and coverage that is reinstated, are left out. Subsection 306(10) of the Regulations then sets out how the benchmarks are recast.

The practical rule for an older policy is to ask before you touch it. Before you convert term coverage inside it, or add underwritten coverage, ask the insurer in writing whether the change engages subsection 148(11). Then have a Chartered Professional Accountant read what that answer means for you, before anything is signed.

What is the 250 percent rule?

It is a second test, aimed at large deposits made late in a contract's life. Subsections 306(6) and 306(7) apply at the tenth policy anniversary and at every one after it. The first condition is that the accumulating fund, ignoring any policy loan, is more than 250 percent of the accumulating fund at the third preceding anniversary.

For anniversaries after 2016, two more conditions apply to every policy, whatever its issue date. The accumulating fund must also exceed a fraction of the total benchmark funds: 3/20 for a policy issued before 2017, and 3/8 for a policy issued after 2016. And subsection 306(7) must not have applied at any of the policy's six preceding anniversaries. When every condition is met, each benchmark is deemed issued on the later of the third preceding anniversary and its original date, and at no other time.

Illustrative example (assumed figures, for the arithmetic only). Suppose your contract reaches its twelfth anniversary with an accumulating fund of $260,000, and the fund at its ninth anniversary was $100,000. Two hundred and fifty percent of $100,000 is $250,000, and $260,000 is more than that, so the first condition is met. The insurer would then check the fraction of the benchmark funds and the six-anniversary condition. Only if both are also met are the benchmarks re-dated.

Re-dating restarts the benchmarks from a later point, which can leave less room under the ceiling than the contract had before. The rule reads numbers, not motives. A deposit made in good faith and a deposit made to shelter a windfall are read the same way. That is why a deposit schedule is agreed with the insurer in advance rather than improvised.

The benchmarks also multiply in ordinary use. Under subsection 306(3), a new exemption test policy is deemed issued each time the death benefit at an anniversary exceeds 108 percent of the death benefit at the later of issue and the preceding anniversary. Paid-up additions raise the death benefit and the accumulating fund together, so they move both sides of the comparison at once. How additions work is covered in paid-up additions.

What moves a heavily funded contract toward the line?

Funding a participating whole life contract close to the ceiling is a deliberate design. It puts more value inside the exempt contract, and it leaves less margin for anything unexpected. Both halves of that trade belong in the decision.

The approach known as The Infinite Banking Concept®, originated by R. Nelson Nash, is applied in Canada by funding a participating whole life contract heavily in its early years, with paid-up additions where the contract allows them. The reason is that deferral inside an exempt contract is worth having. The mark belongs to Infinite Banking Concepts, LLC, with which this practice has no affiliation. Insurance is insurance, not an investment, and the deferral lasts only while the contract stays exempt.

Events that can narrow the room include:

• Dividends above what the design assumed. Dividends are not guaranteed, in either direction, and dividends used to buy paid-up additions add value and coverage at the same time.
• A change in the deposit pattern, or a large deposit after years of smaller ones, which can also bring the 250 percent rule into play.
• A reduction of the death benefit. Subsection 306(5) reduces the benchmarks when coverage is reduced, so the ceiling falls along with the coverage.
• A conversion, or an underwritten addition, on a policy issued before 2017 that engages subsection 148(11) and moves it under the newer rules.

If you want a margin, it is a design choice you make with the insurer and your advisor before the first deposit, and again at each review:

• Ask for an illustration at a deposit level below the stated maximum, and compare the room it leaves at each anniversary with the maximum design.
• Keep deposits on the schedule the insurer tested, and ask before any deposit outside it, large or small.
• After each anniversary, ask for the room that remained, in writing, and keep the letters with the policy.

None of this means you can place unlimited money in a contract and have it grow untaxed; section 306 exists to stop exactly that. Holding the highest practical level of control over the capital flow function in your own affairs, which is what this practice means by Infinite Financial Sovereignty®, includes knowing where that ceiling sits for your contract. It also means staying under it with the insurer's written figures in hand.

What can the insurer do to keep a contract exempt, and what can it cost you?

What an insurer may do is set by your contract, not by the Regulations, and designs differ. Ask for the clause that deals with exempt status. Depending on the contract, the tools it gives the insurer can include:

• Limiting or refusing a deposit that would take the contract over the ceiling.
• Increasing the death benefit, which can raise the benchmark side of the comparison; subsection 306(3) sets when a new benchmark is deemed issued.
• Moving value out of the policy into a side account held outside it.
• Paying value out to you, for example by surrendering paid-up additions.

These adjustments are not tax-neutral. Money paid out of the policy is a disposition under section 148 of the Income Tax Act. For a partial surrender, subsection 148(4) assigns only part of your adjusted cost basis to the part surrendered, so some of the payment can be income in the year it is made, even though you did not ask for it. A side account held outside the policy has its own tax treatment, which your accountant reads. A higher death benefit is more insurance, so ask how the added coverage is paid for under your contract and what it does to your cash values and dividends.

The Regulations take note of these adjustments in two places. For a policy issued after 2016, the forward-looking condition is read without reference to automatic adjustments, so an insurer cannot count on its own future action to pass the test today. And subsection 306(8) supplies a window. A policy that would cease to be exempt on an anniversary is deemed exempt on that anniversary if it would have been exempt had the anniversary fallen 60 days later, or if the person insured dies on the anniversary or within 60 days after it. Those 60 days, counted from the anniversary, are the time an adjustment has to prevent the failure.

Before you fund toward the ceiling, put these questions to the insurer in writing:

1. Which clause of my contract deals with exempt status, and which tools does it give you?
2. In what order are those tools used, and which of them need my consent?
3. What room was left under the ceiling at the last anniversary, and what room is projected at the next one?
4. If you pay value out to keep the policy exempt, how will the amount be reported, and for which tax year?
5. Does a change I am considering (a larger deposit, a reduction, a conversion or an added coverage) affect the test?

What happens on the day a contract stops being exempt?

Two tax events follow a failure, and the first comes at once. Paragraph 148(2)(d) of the Income Tax Act covers a policy last acquired after December 1, 1982 that ceases to be an exempt policy. You, as policyholder, are deemed to have disposed of your interest at that time. The proceeds are deemed equal to the accumulating fund of your interest at that time. You are then deemed to reacquire the interest immediately after, at a cost equal to those proceeds.

The deemed disposition counts as a disposition for subsection 148(1). The amount, if any, by which the proceeds exceed your adjusted cost basis immediately before is included in your income. No cash leaves the contract, so the tax is paid from other money. The paragraph has one exception. It does not apply when the policy ceases to be exempt as a consequence of the death of the person insured, or at a time when that person is totally and permanently disabled.

Because you reacquire at a cost equal to the proceeds, the growth taxed on that day is not taxed again later. On our reading of the definition of adjusted cost basis, your cost in the contract starts again from the accumulating fund of that day, and later premiums and adjustments build from there.

Illustrative example (assumed figures, for the arithmetic only). Suppose your contract ceases to be exempt at an anniversary. The insurer reports an accumulating fund of $180,000 on that day and an adjusted cost basis of $110,000 immediately before. The deemed disposition puts $70,000 in your income for that year ($180,000 minus $110,000), and no money is paid to you. On the reading above, your cost then starts again at $180,000. At the next anniversary day, suppose the accumulating fund is $191,000, and premiums and other adjustments have moved your adjusted cost basis to $186,000. Section 12.2 then includes $5,000 ($191,000 minus $186,000). The tax on each amount depends on your own marginal rate, which your accountant can apply.

What happens at each anniversary after that?

The second event repeats. Subsection 12.2(1) applies to an interest in a life insurance policy, other than an exempt policy, last acquired after 1989, leaving aside annuity contracts and the other exclusions it lists. On each anniversary day of the policy in a taxation year, you include in income the amount by which the accumulating fund of your interest exceeds its adjusted cost basis on that day. Subsection 12.2(11) defines the anniversary day as the day one year after the day before the policy was issued, then each year after that. The date comes from your contract, not from the calendar year.

Each amount included under section 12.2 is added to your adjusted cost basis under the definition in subsection 148(9). The next comparison starts from a higher base, and a later surrender or policy loan does not tax the same growth a second time. What is gone is the deferral that made the contract attractive, and the yearly tax is paid from money outside the contract.

Federal rules apply across Canada. If you live in Quebec, you also file a Quebec return with Revenu Québec, so ask your accountant to read the Quebec treatment alongside the federal one.

Is the death benefit taxed if the policy is no longer exempt?

The rule that keeps a death payment from being a disposition is written for exempt policies. In the definition of disposition in subsection 148(9), paragraph (j) excludes a payment made in consequence of the death of a person whose life was insured under an exempt policy. It also covers a policy last acquired before December 2, 1982.

For a policy that is not exempt and was last acquired after December 1, 1982, paragraph 148(2)(b) applies when the policyholder or the person insured dies. The policyholder is deemed to have disposed of the interest immediately before the death. What that produces, and on whose return, depends on the figures on that date, and it is work for the estate's accountant. It is one more reason to treat exempt status as worth protecting. The wider picture of how life insurance is taxed is covered in is life insurance taxable in Canada.

Do policy loans and withdrawals change the test?

A policy loan does not create room under the ceiling. Paragraph 306(1)(a) and the 250 percent rule both measure the accumulating fund without regard to any policy loan, so borrowing against the policy leaves the comparison where it was.

A policy loan is still a tax event of its own. It is an advance from the insurer, and the interest is owed to the insurer. Under the definition of disposition in subsection 148(9), paragraph (b), a policy loan is a disposition. Only the part of the loan above your adjusted cost basis immediately before it is income, the loan lowers that cost basis, and repaying it restores it. That applies whether or not the policy is exempt. The detail is in when a policy loan becomes taxable.

A withdrawal works differently. Surrendering part of the policy lowers the accumulating fund, and where coverage falls, subsection 306(5) lowers the benchmarks too. The net effect on the room is a calculation for the insurer, and the tax on the withdrawal follows subsection 148(4), which prorates your adjusted cost basis.

Can a contract that lost its exemption get it back?

On our reading of section 306, no. Paragraph 306(1)(c) requires the ceiling to have been met at every earlier anniversary. A contract that went over at one anniversary, outside the 60-day relief, cannot meet that condition again, however small its fund becomes later and however much coverage is added. I found no provision in the section that restores the status, forgives the failure or starts the record again.

The relief in subsection 306(8) works before a failure is recorded, not after. If the insurer did not act inside the window, or you declined the adjustment, the Regulation offers no second window. If anyone tells you a particular contract can be made exempt again, ask them to name the provision in writing, and take the answer to a Chartered Professional Accountant.

A new contract issued later starts its own record under section 306. It is a separate contract, with its own underwriting, its own cost at an older age and its own first anniversary. The failed contract's history does not carry over to it.

What should you do if the insurer writes about your exempt status?

Act inside the dates. The 60 days in subsection 306(8) run from the anniversary, not from the date on the letter. Work through these steps in order:

1. Ask which anniversary the letter concerns and which condition in subsection 306(1) is at issue.
2. Ask whether the 60-day relief has been assessed, and the last date on which an adjustment can still count.
3. Ask which adjustments your contract allows, whether each needs your consent, and whether any would pay value out to you.
4. Ask whether the policy has already ceased to be exempt, and on what date.
5. Ask for the accumulating fund and the adjusted cost basis on that date, and how the insurer will report any income, on which slip and for which year.
6. Take all of it to a Chartered Professional Accountant before you sign anything. If you live in Quebec, the accountant also covers your Revenu Québec return.
7. If you disagree with how the insurer handled it, use its complaint process and ask for its final position in writing. In every province, including Quebec, the OmbudService for Life and Health Insurance can then review it; Quebec residents can also turn to the Autorité des marchés financiers. Deadlines can apply, so consult a lawyer (in Quebec, a lawyer or notary) promptly.

Who this suits, and who it does not

It suits an owner funding a participating whole life contract toward the ceiling who wants to know what the ceiling is made of, what the insurer's adjustment clause does and what a failure would cost. It suits anyone who was told that growth inside a policy is sheltered without limit. It suits the owner of a policy issued before 2017 who is weighing a conversion or an added coverage.

It does not suit someone looking for a way to place an unlimited sum in a policy and defer tax on all of it, because section 306 is the reason that cannot be done. If your contract has already failed, the useful conversation is with a Chartered Professional Accountant holding the insurer's figures. And if you want the figure for your own contract, it comes from the insurer's calculation and from nowhere else.

I am paid by commission from an insurer when a contract is placed; reading this costs you nothing. A participating whole life contract is insurance, not an investment. Its guaranteed values are set out in the contract, its dividends are not guaranteed, and an illustration is not a promise. Exempt status is a characteristic the contract keeps while it meets the test, not a guarantee, and the tax consequence of losing it belongs with a Chartered Professional Accountant.