Can critical illness insurance have tax advantages?
Different types of insurance have different tax implications. FAQ #30 Term Life Insurance answers the question about tax advantages to term life insurance and corporate ownership. Critical illness insurance has its own rules.
Critical illness insurance has one very important difference with term life insurance. Term life insurance is specifically recognized in the tax act and is added to a “tax free” capital dividend account when it is paid out. Critical illness insurance is not paid to this “tax free” capital dividend account when it is paid out. So its payout is by default taxable unless we can argue some other reason for it not being taxable. Valid arguments are (1) it was not deducted to start with and (2) it is not actually income to the recipient.
Tax planning professionals (most of them paid by insurance companies) have come up with several schemes to try to make the payout not taxable while having the premiums tax deductible. The most popular scheme works like this. The company buys critical illness insurance and deducts the premiums just as it would deduct any other insurance premium other than life insurance. Thus, when it is paid out to the company it is taxable income. This does not protect the company from the tax, but does make it taxable at the low corporate rate in most cases. Simultaneously, the insured individual buys an “insurance” policy that bets against the critical illness policy and pays out only when the critical illness does not pay out. So if the individual never uses the critical illness policy, they get a payout. This second policy is never deducted (see option 1 above) and thus, is not taxable when paid out.
The second option is more tenuous and rests on CRA not following all of the steps of the payout. There are schemes that involve burying the critical illness insurance in a package and then when a payout is made it is not directly connected to a deducted payment, thus it is not income to the recipient. The rules are complex here and I suspect that talented tax planners can come up with technically workable schemes. The caveat is the old saying “if it walks like a duck and quacks like a duck; it is a duck”.
Consult us before signing an insurance contract. This will allow us to comment in a timely manner on who or what might be taxed if there is a payout. Each circumstance is different and tax laws continue to change. Perhaps in future there will be a “tax free” rule written in to the tax act for this type of insurance.Download a copy of this issue