When a Policy Loan Becomes Taxable

A policy loan is an amount the insurer advances to the policyholder under the terms of the contract, and the Income Tax Act treats that advance as a disposition of an interest in the policy. This page is about one narrow question: the exact point at which such a loan produces an amount to include in income, and why. It does not explain how a policy loan works in general, which is on the policy loans page, and it does not define the adjusted cost basis from scratch, which is in the glossary entry on the adjusted cost basis.

Everything below is general information written by a licensed insurance professional, and it describes the mechanism of the statute rather than any reader's return. What a particular loan on a particular contract does to a particular tax year is a question for a Chartered Professional Accountant with the insurer's figures in hand. Canadian Wealth Creation Centre Inc., trading as IBC Financial, is not authorized to give legal, tax or notarial advice and gives none here.

When does a policy loan become taxable?

At the moment the proceeds of the loan exceed the adjusted cost basis of the policyholder's interest, measured immediately before the loan is made. Below that line, nothing is included in income. Above it, the excess is included in the year the loan is taken. The line is a number the insurer holds, and it moves every year.

That is the whole rule, and it comes from two places in one section of the Act. Subsection 148(1) of the Income Tax Act requires a policyholder to include in income, in respect of the disposition of an interest in a life insurance policy, the amount by which the proceeds of the disposition that the policyholder became entitled to receive in the year exceed the adjusted cost basis of that interest immediately before the disposition. Subsection 148(9) then defines each of those terms, and paragraph (b) of its definition of disposition names a policy loan made after 31 March 1978 as one.

So the common sentence, that a policy loan is "tax free", is true only while the running total stays under the basis and false the moment it crosses. Nothing in section 148 exempts policy loans as a class. It measures each loan against a figure, and the figure decides, and that measurement has to be understood before a loan is requested rather than discovered on a tax slip afterwards.

The strategy is the Canadian application of the approach known as The Infinite Banking Concept®, originated by R. Nelson Nash; the mark belongs to Infinite Banking Concepts, LLC, with which this practice has no affiliation. Where this page says the strategy, it means the use of policy loans against a participating whole life contract, and the taxable point described here is the single fact about those loans most often left out of what is written about the strategy elsewhere.

Why is a policy loan a disposition at all?

Because the Act says so in terms. Subsection 148(9) of the Income Tax Act defines a disposition of an interest in a life insurance policy to include a surrender, a policy loan made after 31 March 1978, dissolution on maturity and a disposition by operation of law. A policy loan sits beside a surrender.

The same subsection defines a policy loan as an amount advanced by an insurer to a policyholder in accordance with the terms and conditions of the life insurance policy. Two elements matter. The lender is the insurer, not a third party. And the advance is made under the contract, which is why the contract rather than a separate loan agreement governs the interest rate, the security and the effect on what is paid at death.

The proceeds of the disposition for a policy loan are defined with a ceiling. Under subsection 148(9), in respect of a policy loan made after 31 March 1978, the proceeds are the lesser of the amount of the loan, other than the part applied immediately after the loan to pay a premium under the policy, and the amount by which the cash surrender value immediately before the loan exceeds the outstanding balances of any earlier policy loans. So the proceeds can never exceed the room left in the cash surrender value, and a loan that merely refinances an existing balance does not create fresh proceeds.

The consequence that surprises people is that nothing has to be sold and no gain has to be realized in the ordinary sense. The policyholder still owns the contract, the contract is still in force, and the cash surrender value is still growing on a tax deferred basis. The disposition is a statutory event, not a commercial one, and it is triggered by the advance itself.

How is the adjusted cost basis built, and how does it fall?

The adjusted cost basis is a running formula, defined in subsection 148(9) of the Income Tax Act as additions minus subtractions, and its value on a given day is what a policy loan is measured against. It rises with premiums and amounts already taxed. It falls with what has been taken out and, yearly, with the cost of the insurance.

On the addition side, the definition counts the cost of an interest in the policy acquired by the policyholder and every amount paid by or on behalf of the policyholder in respect of a premium under the policy. It also adds back every amount in respect of an earlier disposition of an interest in the policy that was required to be included in the policyholder's income, so an amount that has already been taxed once is not measured a second time. And it adds repayments of policy loans, within a ceiling this page returns to below.

On the subtraction side, the definition removes the proceeds of every earlier disposition the policyholder became entitled to receive, which means each policy loan lowers the basis by its own proceeds as soon as it is made. For a policy acquired after 1 December 1982 it also removes, year by year, the net cost of pure insurance as defined by regulation and determined by the issuer of the policy in accordance with the regulations. That yearly charge is the one that catches long standing contracts.

The net cost of pure insurance is, in plain terms, the mortality cost of carrying the amount at risk for one more year, and it rises with age. On a contract that has finished paying premiums, the additions stop and the yearly subtraction continues, so the basis drifts toward zero and, once there, stays there. This is why a policy loan on an old contract can be included in income from the first dollar, while the same loan on a young contract with years of premiums behind it may produce nothing. The elements of the definition are set out in the glossary entry; the figure itself comes only from the insurer.

What happens in the year the loan crosses the line?

The excess is income of that taxation year, and it is ordinary income rather than a capital gain. Subsection 148(1) of the Income Tax Act includes the amount by which the proceeds exceed the adjusted cost basis immediately before the disposition, in the year the proceeds became receivable. The loan arrives; the inclusion arrives with it.

The arithmetic is short. Suppose, purely as arithmetic and not as any contract's values, that the adjusted cost basis immediately before a loan is 10,000 and the proceeds of the loan are 15,000. The excess of 15,000 over 10,000 is 5,000, and 5,000 is included in income for that year. The basis after the loan is the old basis, less the 15,000 of proceeds, plus the 5,000 that was included, which is zero. The next loan on the same contract is then measured against zero, and every dollar of its proceeds is included.

Reverse the order of the numbers and the result reverses with it. A basis of 15,000 and proceeds of 10,000 produce no inclusion, and a basis of 5,000 afterwards. The loan was not free of tax; it was under the basis. The same policyholder, the same contract and the same request one year later, after another year's net cost of pure insurance has come off, can produce a different answer. That is what it means to say the line moves.

Two practical points follow. The insurer determines and reports the amount included, because only the insurer holds every element of the definition, and the policyholder does not get to choose which loan crosses the line. And the inclusion is not withheld at source from the loan, so the cash arrives whole and the tax arrives with the return. A Chartered Professional Accountant should see the insurer's figures before a large loan is taken, not after.

What are the limits and drawbacks of borrowing this way?

A policy loan is a real debt to the insurer, it bears interest at the contract's rate, it reduces what is paid at death by the balance and accrued interest, and it can be included in income under section 148 of the Income Tax Act on the day it is taken. No credit check softens any of that.

The taxable point is the drawback this page exists to describe, and it is worst on the contracts people are most tempted to borrow against: paid up, long in force, with a large cash surrender value and an adjusted cost basis near zero. On such a contract the entire loan can be income in the year it is taken. The larger the value that has been left to grow, the more likely it is that the basis has been eroded beneath it.

Interest is the second drawback. Unpaid interest is usually added to the balance under the contract's terms, and the balance compounds against the cash surrender value. Whether interest added to the balance is itself treated as a further policy loan, and therefore a further disposition, is a question this page does not answer; a Chartered Professional Accountant confirms it against the contract and the insurer's reporting. A balance that reaches the cash surrender value can bring the contract to an end, and a contract that ends with a loan outstanding is itself a disposition with its own inclusion.

Where a policy dividend is used to reduce a loan or its interest, that is a matter of the contract's own provisions and the insurer's practice, and policy dividends are not guaranteed. The contractual guarantees are those of the issuing insurer and no other. None of this makes a policy loan a bad tool. It makes it a tool with a number attached, and the number is the adjusted cost basis on the day of the loan.

Does repaying the loan undo the tax?

Partly, by deduction rather than refund, and only to the extent an amount was actually included. Paragraph 60(s) of the Income Tax Act allows a deduction of the repayments made in the year in respect of a policy loan, not exceeding what was previously included under subsection 148(1) from that loan, less repayments already deducted in an earlier year.

Read that ceiling carefully, because it does two things. It ties the deduction to the inclusion, so a repayment of the part of a loan that was never taxed produces no deduction at all, since there was nothing to reverse. And it tracks earlier deductions, so the same inclusion cannot be reversed twice by repaying, borrowing again and repaying again. The deduction is a mirror of the inclusion, no larger and no earlier.

The repayment also rebuilds the adjusted cost basis. The definition in subsection 148(9) adds, as one of its elements, amounts in respect of the repayment of a policy loan, up to a ceiling set by a formula that starts from the proceeds of the disposition in respect of that loan and comes down by amounts that have been deductible under paragraph 60(s). In the arithmetic above, repaying the 15,000 loan would give a deduction of up to 5,000 in the year of repayment and put the untaxed 10,000 back into the basis.

Timing is everything in that mechanism, and it is the policyholder's responsibility. A repayment made in a year with little other income and a repayment made in a year with a great deal of it are the same repayment with different results, and the deduction cannot be carried to another year on its own terms. The order of loans and repayments across several years is arithmetic a Chartered Professional Accountant checks against the insurer's statements.

Is a loan used to pay the premium counted?

Not in its proceeds, and that is where the Act deals with it. A policy loan used to pay a premium is still a disposition under paragraph (b) of the definition in subsection 148(9) of the Income Tax Act. The measure changes: the proceeds exclude the part applied at once to a premium under the policy.

With that part removed from the proceeds, subsection 148(1) has nothing from it to compare against the basis, so a loan taken and applied at once to the premium produces no inclusion on account of that part. The exclusion sits in the definition of proceeds of the disposition rather than in the definition of disposition itself, and that is a distinction worth keeping, because the loan remains a loan for every other purpose: it bears interest, it reduces what is paid at death, and it sits in the outstanding balance that caps the proceeds of every later loan.

The exclusion is narrow by design. It covers a premium under the policy, paid immediately after the loan, as the contract's own terms provide. It does not cover a loan taken in cash and used for a premium later, and it does not cover an amount used for anything else. The premium paid with the loan is itself an addition to the basis under the definition, so a contract kept in force this way has a basis that rises by the premium at the same time as a balance that rises by the loan. How the insurer has reported a particular arrangement is what a Chartered Professional Accountant reads.

How is a collateral loan from a third party different?

It is not a disposition. Subsection 148(9) of the Income Tax Act says a disposition does not include an assignment of all or any part of an interest in the policy for the purpose of securing a debt or a loan other than a policy loan. A third party's loan, secured by an assignment, is that kind of debt.

The distinction turns on who advances the money. A policy loan is advanced by the insurer under the contract, which is why the Act can define its proceeds by reference to the cash surrender value and treat it as a partial taking of what the contract holds. A third party's loan is advanced by the lender under the lender's own agreement, with the contract pledged as security, and the contract's value is untouched until a default. The contract stays whole; the debt sits beside it.

That is not the same as saying the third party route is better. It carries its own costs, its own rate, a lender's terms and covenants, a lender who can call the loan, and a different set of consequences at death, where the lender is paid first from what the contract pays. Which of the two suits a given situation depends on the adjusted cost basis, the size and purpose of the advance, the cost of the credit and what the household can carry. The two routes are set out side by side on the page on a policy advance and other credit, which this page does not repeat.

Who this suits, and who it does not

This page suits a policyholder who has been told that a policy loan is never taxed and wants the condition that sentence leaves out. It suits the owner of a contract long in force, or finished paying premiums, who is considering a first loan and has never asked the insurer for the adjusted cost basis.

It also suits anyone deciding between an advance from the insurer and a loan secured on the contract from someone else, who needs to know that only one of the two is a disposition, and who wants the reason for the difference stated from the statute rather than from a brochure.

It does not suit a person who wants a figure for their own contract, because that figure exists only in the insurer's records and only the insurer can state it. It does not suit anyone treating the loan as a way to draw income from the contract without consequence; above the basis it is income, and below the basis it is a debt with interest that reduces what is paid at death. And it does not suit a reader looking for tax advice, because none is given here, and the year in which a loan is taken or repaid is a decision to make with a Chartered Professional Accountant and the insurer's statement on the table.

Everything here is written by a person paid by commission from an insurer when a contract is issued, which is stated at the foot of every page. Participating whole life insurance is insurance, it is not an investment, and the tax treatment of a policy loan is a characteristic of the contract rather than a reason to own one. Knowing where the line sits before borrowing is part of what the practice calls Infinite Financial Sovereignty®, which describes the state of holding the highest practical level of control over the capital-flow function in one's own affairs, and control of that function begins with knowing which dollar is taxed.