Section 1406 of the Income Tax Regulations (“ITR”) sets out rules for calculating life insurance policy reserves under s. 1404 and 1405. Section 1406 is being amended in response to decisions of the Tax Court of Canada (“TCC”) and the Federal Court of Appeal (“FCA”) in National Life Assurance Co. v. R., 2006 TCC 551 (aff’d 2008 FCA 14) (“National Life Assurance”). The case involved the proper treatment of certain negative amounts which arose in calculating the policy reserves.
Subparagraph 138(3)(a)(i) of the Income Tax Act (Canada) (the “Act”) allows life insurers to deduct policy reserves on life insurance policies in calculating their income. Provisions of the ITR set out the rules for calculating the “maximum tax actuarial reserve” (“MTAR”) that can be deducted. A portion of the MTAR formula was in issue in National Life Assurance, namely, the “A” amount calculated under ss. 1404(3) (the lesser of total reported reserves and the policy liability at the end of the taxation year). Para. 1406(b) requires that “A” be determined without reference to any liability in respect of a “segregated fund”, other than a liability in respect of a guarantee relating to a segregated fund policy.
National Life Assurance
National Life Assurance involved the calculation of the MTAR for the 1997 and 1997 taxation years for a particular product called “UltraFlex”. The taxpayer made three calculations in relation to variable investments in segregated funds. The second calculation yielded a negative amount. The first and second calculations were omitted from the “A” component of the reserve calculation, pursuant to para. 1406(b). Had the negative component calculated under the second calculation been included, this would have reduced the reserve deduction to which the taxpayer was entitled. The Minister of National Revenue (“Minister”) reassessed the taxpayer by including the negative portion of the calculation in the “A” calculation.
Hershfield J. held that the negative component was not a liability, but was properly excluded from the calculation because it was calculated “with reference to” liabilities in respect of segregated funds. The Minister unsuccessfully appealed the TCC judgment to the FCA.
The FCA’s approach was slightly different than the TCC’s approach. The FCA stated that the starting point for determining the “A” amount is to calculate the reported reserves and then the policy liabilities for those policies, which is an actuarial exercise yielding a calculation of liability in accordance with actuarial principles. This result is then subject to para. 1406(b), the purpose of which is to reconcile differential treatments under regulatory and income tax law.
The scheme of the Act concerning segregated funds is unique. The taxpayer successfully argued that its role in relation to segregated funds is bifurcated, between acting as an insurer and acting as a trustee for a segregated fund. The taxpayer’s liabilities in relation to the segregated funds were in its capacity as a trustee, not an insurer. Consequently, it argued that it should not be allowed to claim a reserve for obligations in its capacity as a trustee. Thus, para. 1406(b) begins with the actuarially determined liability, then reduces it by the life insurer’s liability to make “variable benefit payments” (which in this case were the minimum guarantee amounts in the third part of the “A” calculation). The negative amount in the second part of the “A” calculation was considered to relate to the taxpayer’s obligation to make variable benefit payments. Consequently, the negative second part of “A” was to be excluded from the calculation of the MTAR.
The proposed amendment would modify para. 1406(b) to require the exclusion of “any liability to pay to a policyholder an amount out of a segregated fund.”
According to the Explanatory Notes, policy reserves calculated under s. 1404 and 1405 of the ITR will include not only guarantees in respect of segregated fund policies, but also the portion of the policy reserves that relate to negative segregated fund policy reserves. The amendment is intended to apply to the 2012 and subsequent taxation years.