When disability insurance benefits are not tax exempt

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One of the main advantages of life insurance is that the proceeds received by a beneficiary of a life insurance policy on the death of the insured person can be received by that beneficiary tax-free. But when it comes to benefits received under a disability insurance policy, the tax rules can get a little blurry.

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Disability insurance (“DI”) is a form of insurance coverage that gives you protection to replace income if you become disabled and unable to work. It is often offered to employees as part of a group plan, but it can also be purchased on its own, which is usually the case for business owners or independent professionals.

If you become disabled, the general tax rule is that if you have paid the premiums under the disability insurance policy, any periodic disability payment received from the insurer will be tax free. However, if your employer pays the premiums under the DI policy and does not report them as a taxable benefit for your employment, any future benefits received under the DI policy will be fully taxable.

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However, a recent tax case shows that what appeared to be tax-free DI benefits to the policy purchaser was not considered tax-free by the Canada Revenue Agency.

The case involved a dental surgeon in Sherbrooke, Quebec, who was reassessed by the tax authorities for her 2009, 2010 and 2011 tax years. The CRA added $ 88,150 to her income. from 2009, $ 249,417 to her 2010 income and $ 114,116 to her 2011 income to reflect the insurance benefits she received under two professional overhead disability insurance policies issued by the company. Great-West Life (GWL) insurance.

The taxpayer testified that she purchased three separate disability insurance policies from GWL. The first policy, called “Professional Overhead Protection”, was issued in 1991 and offered monthly protection of $ 3,000 at a monthly premium cost of $ 57. The second policy, called “Professional Overheads”, was issued in 2007 and offered monthly protection of $ 15,000 in exchange for a monthly premium of $ 408. The third policy, entitled “Disability Insurance Plan – Professional”, was issued in 2008 for a monthly premium of $ 883 and offered monthly protection of $ 8,000.

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In court, the taxpayer provided proof that she had paid the premiums for these three policies out of her personal bank account and that in all the years she had never deducted the premiums she had paid to as an expense of its taxable income.

In May 2009, the taxpayer became disabled due to illness, but nonetheless continued to operate her clinic until July 2011, using other dentists and paying them 50 percent of their billed income.

She began receiving benefits under her three policies, all of which were deposited into a personal bank account (as opposed to her clinic’s business account). She did not include them in her professional income for the years in question, considering that they were tax-free disability benefits.

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Following a tax audit, however, the CRA reassessed her and included the disability benefits she received under the two overhead policies in her business income. He did not reassess her for the benefits she received under the third policy since it was a personal DI product, the benefits of which were not taxable.

The taxpayer’s main argument was that DI premiums are considered to be personal expenses which cannot be deducted in calculating the insured’s income under the Tax Act and that, therefore, the benefits paid under an DI policy may not be taxable.

At trial, the dentist testified that she believed the three disability insurance policies purchased from GWL should all be treated the same as tax-free policies and introduced the emails and letters exchanged into evidence. with GWL regarding the tax treatment of its insurance policies, confirming that benefits paid under these policies are not taxable.

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In court, the CRA called a product expert from GWL to testify as to the nature of the three policies the dentist had underwritten. Unfortunately, the expert testified that GWL provided the dentist with inaccurate information about the tax treatment of DI benefits.

The CRA’s position was that the benefits paid under the two overhead policies were a reimbursement of business expenses that were intended to keep the office running for 24 months in order to allow the dentist to reorganize his business if the disability persisted.

In order for benefits to be paid under both overhead policies, the practice had to continue to be operated by the insured during the period of disability and proof of overhead costs associated with operating the clinic had to be presented. to GWL monthly. These benefits are intended to replace the operating expenses of the dental clinic that were included in the calculation of the clinic’s net operating income and deducted for tax purposes.

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This can be contrasted with the third policy where the benefits were not taxable because the only condition required for payment was that the insured was disabled. Benefits would continue to be paid for as long as the insured’s disability lasts, whether or not their practice continues.

The judge referred to the substitution principle (the “surrogatum principle”) in which the Supreme Court, in a landmark decision of 2005, concluded that the tax consequences of DI benefits are established on the basis of what the amount was supposed to replace. Under this principle, the tax treatment of DI benefits was intended to replace the overhead costs of running a dental clinic. The judge concluded that since the source of the insurance benefits is the taxpayer’s dental business, the insurance benefits paid to the taxpayer must be included in the calculation of his business income.

As for GWL’s role in providing misinformation, a company spokesperson admitted to being “aware of the decision…. Although we admitted that we provided incorrect information regarding the taxation of the benefits, this information was only provided to the claimant after they had already filed their income tax returns. Benefits under the overhead office policies are taxable.

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Jamie Golombek, CPA, CA, CFP, CLU, TEP is Managing Director, Tax and Estate Planning with the CIBC Financial Planning and Advisory Group in Toronto.