Tax Insights: Finance releases draft legislative proposals – Taxation of insurance contracts under IFRS 17

Issue 2022-24

In brief

On August 9, 2022, the Department of Finance (Finance) released draft legislative proposals to implement numerous 2022 federal budget and other measures, including the much-anticipated legislation (and explanatory notes) that provide a more comprehensive policy direction on how insurance companies will be taxed under International Financial Reporting Standard (IFRS) 17. In its April 7, 2022 budget, the federal government did provide the insurance industry with guidance as to how certain aspects of IFRS 17 would be addressed for tax purposes upon its implementation on January 1, 2023, but it did not release any draft legislation at that time.

This Tax Insights discusses the key aspects of the proposed legislative framework for IFRS 17 for tax purposes. It also highlights the two new tax regimes announced in the 2022 federal budget that will apply to members of a bank or life insurer group: the Canada Recovery Dividend and the Additional Tax on Banks and Life Insurers.

In detail

Background

In May 2017, the International Accounting Standards Board released IFRS 17, which will replace IFRS 4 for accounting for insurance contracts and will be effective January 1, 2023. IFRS 17 will introduce new concepts central to the new insurance accounting regime, which substantially change financial reporting for insurance and reinsurance companies, including:

• life insurers – which includes annuity, accident and health insurance providers
• property and casualty (P&C) insurers – which includes auto, personal property, commercial property, liability and title insurance providers

IFRS 17 will significantly alter the measurement of income from insurance contracts, particularly those that relate to life and other long-term insurance contracts.

The unique nature of insurance, where premiums are pooled and then invested to pay claims, often years after contracts are sold, has led to specific rules being developed regarding the computation of income for tax purposes. These special tax rules permit insurers to deduct actuarially computed policy reserves in advance of actual outflows, in recognition of the future claims that will be paid. Under IFRS 17, reserves will continue to be determined actuarially when insurance contracts are sold; however, IFRS 17 will introduce a new reserve, the contractual service margin (CSM), which will represent a portion of the profits on underwritten insurance contracts that is deferred and gradually released into income over the estimated life of the underlying group of insurance contracts.

The 2022 federal budget provided some indication of the federal government’s policy direction that would be taken to accommodate IFRS 17 for tax purposes, however, it did not provide comprehensive guidance or draft legislation. The August 9, 2022 draft legislative proposals, therefore, provide some welcome direction to the insurance industry as to how they will be taxed under IFRS 17.

2022 federal budget

The 2022 federal budget proposed the following specific IFRS 17 changes:

CSM deductibility

The 2022 federal budget provided some concessions on the position originally announced in Finance’s backgrounder that was released in May 2021. The deductibility of the CSM for tax purposes will depend on the type of insurance contract, with the intent of aligning the recognition of income with the time that they perceive the relevant economic activities to occur. For:

• life insurance contracts – a proportion of the CSM will be deductible as follows:
  • the CSM associated with segregated funds will be wholly deductible
  • 10% of the remaining portion of the CSM (excluding the amount attributable to segregated funds) will be deductible
• mortgage and title insurance contracts – 10% of the CSM that is attributable to mortgage and title insurance contracts will be deductible
• group accident and sickness insurance contracts – 10% of the CSM that is attributable to group accident and sickness insurance contracts for either life or non-life insurance businesses will be deductible
• property and casualty insurance contracts – the deductibility of reserves is expected to be maintained in accordance with current principles, which implicitly includes any component of reserves attributable to the CSM (except for mortgage and title insurance contracts as noted above)

Transition

The 2022 federal budget established that any movement in reserves as a result of adopting IFRS 17 for tax purposes will be smoothed over a five year transition period, taking into consideration the potential CSM limitations noted above. It also indicated that mark-to-market gains or losses arising on the transition to IFRS 9, “Financial Instruments” (which insurers are required to adopt on January 1, 2023) will be subject to a five year transition period.

Part VI Financial Institutions Capital Tax

The 2022 federal budget announced that Finance intends to adjust the Part VI tax base due to the transition to IFRS 17, by:

• including the non-deductible portion of the CSM and any deferred tax assets in the Part VI tax base
• adjusting the reclassification of gains and losses recorded in accumulated other comprehensive income

These changes, in particular the ending of the adjustment for any deferred tax assets in a life insurer’s Part VI tax base, are expected to result in a significant increase in the Part VI tax base for many life insurers. 

August 9, 2022 draft legislative proposals

The draft legislative proposals provide a legislative framework for IFRS 17, which is generally consistent with the 2022 federal budget proposals described above. In addition, it provides specific insights on the following key areas:

Overall approach to life and non-life insurers

Although the 2022 federal budget provided a distinction as to how the CSM would be treated for life and non-life insurers, Finance’s original comments in its May 2021 backgrounder that the CSM would not be deductible to any insurer suggested that the dichotomy that currently exists for life and non-life insurers may not continue under IFRS 17. The draft legislative proposals retain a clear distinction between the taxation of life and non‑life insurance businesses – particularly with respect to the deductibility of reserves. 

Deductibility of reserves

Currently, insurers are able to deduct any amount in respect of life and non-life insurance policy reserves, up to the maximum amount prescribed by regulation. All reserves in respect of life and non-life insurance policies are also determined net of any reinsurance recoverable. The draft legislative proposals amend the prescribed formula to incorporate IFRS 17, in a manner aligned with the policy direction provided in the 2022 federal budget. Key positions relating to reserves follow:

• CSM – The limitations relating to the deductibility of the CSM for certain classes of insurance outlined in the 2022 federal budget were generally included in the draft legislative proposals as described. However, the proposed legislation clarifies that group accident and sickness insurance (written by both life and non‑life insurers) will be subject to the 10% limitation.
• 95% limitation (non-life insurance) – The 95% limitation that currently applies to incurred but not reported (IBNR) and unpaid claims reserves for non-life insurers will apply to liability for incurred claims (LIC) in respect of a non-life insurance business under IFRS 17.
• 95% limitation (life insurance) – While life insurers are currently subject to a 95% limitation with respect to IBNR reserves, this limitation will no longer apply to LIC reported in respect of a life insurance business under IFRS 17.
• Adjustments for certain balances – It is widely known that the CSM, LIC and liability for remaining coverage (LRC) potentially include balances that would not have been included as an appropriate policy reserve for tax purposes under IFRS 4. These include:
  • components of income and sales taxes
  • funds withheld for certain insurance contracts
  • amounts previously included in income for tax purposes (e.g. premiums receivable)
  • amounts previously deducted for tax purposes (e.g. commissions payable)

The draft legislative proposals include adjustments to ensure these amounts are not included in determining a particular reserve for tax purposes.  

• Calculation of reserves – The definitions of all key reserve balances in the draft legislative proposals also include:
  • a reference to amounts reported to the relevant authority, explicitly defined as OSFI or similar provincial regulator for insurers operating in Canada
  • additional wording referencing reserves calculated using “reasonable assumptions'' – a term that was not defined in the proposed legislation,

as components of a “greater than” alternative reserve calculation method. Finance did not describe the intent of these changes in their explanatory notes. 

• Discretionary nature of reserves – The current scheme of the Income Tax Act permits insurers to deduct insurance reserves up to the maximum permissible amount on a discretionary basis. While the draft legislative proposals alter the quantification of the maximum reserves that may be deducted for tax purposes, the discretionary nature of the deduction has been retained.

Treatment of reinsurance contracts

The draft legislative proposals provide clarity on how reinsurance contracts will be treated for tax purposes under IFRS 17, especially given the changes to the presentation of reinsurance contracts compared to IFRS 4, and its interaction with determining policy reserves for tax purposes under current regulations. 

The presentational differences of reinsurance contracts held under IFRS 17 mean that the current approach to determining policy reserves for tax purposes net of reinsurance recoverable amounts could be problematic to the extent a particular insurer reported a liability in respect of a particular group of reinsurance contracts held. The draft legislative proposals address this concern by including a mechanism to determine policy reserves which accommodates positive and negative amounts. Otherwise, determining the appropriate policy reserve for tax purposes for reinsurance contracts mirrors that of other reserves – including applying the appropriate limitation to the CSM and adjusting for taxes, receivables, payables and funds withheld.

The draft legislative proposals do not separately contemplate written reinsurance contracts because their treatment for tax purposes will be determined by the appropriate components of the CSM, LRC and LIC. Although there may be differences between the accounting model used for direct written liabilities and the subsequent reinsurance of the same group of insurance contracts, any mismatch in the accounting treatment will apparently be respected and followed for tax purposes.

Deferred acquisition costs

Non-life insurers are currently required to amortize expenses incurred on acquiring an insurance policy with a coverage period that exceeds 12 months over the coverage period of the policy for tax purposes. Lack of a clear methodology to apply this provision has led to uncertainty, inconsistency and an administrative burden to track these expenses for many P&C insurers.

The draft legislative proposals include a provision that will deem outlays or expenses incurred on acquiring an insurance policy at any time before the policy is issued to have been incurred as services rendered in the year the policy is issued. This provision will apply to all insurers for taxation years that begin after 2022. While the P&C industry had lobbied for the existing provision to be repealed or adjusted to align tax with accounting, the proposed legislation provides a limitation on the ability to claim a deduction for tax purposes until the year the underlying policy is recognized. In addition, the rules regarding the reversal of adjustments on the transition to IFRS 17 include a specific adjustment for acquisition costs incurred before 2023, which will continue to be deducted consistently over the period of coverage of the existing policy.

Canadian investment fund (CIF) regime

The longstanding tax policy that Canadian resident multinational life insurers and non-resident insurers operating in Canada are not liable for income tax on income from a foreign insurance business will continue under IFRS 17.  

The current rules, which are complex and include numerous multi-component formulas and detailed definitions, allocate investment income to an insurance business carried on in Canada. These rules involve computing the relevant amount of Canadian reserve liabilities (CRLs) and the CIF for the year, which will clearly be quantitatively impacted by the implementation of IFRS 17.

The draft legislative proposals include amendments that retain the existing tax policy, while also incorporating changes to reflect the concept of the CSM. Specifically, the rules are amended to exclude 90% of the CSM for certain policies, namely, life insurance policies (other than segregated fund policies) and non-cancellable or guaranteed renewable accident and sickness policies, consistent with the overall treatment of the CSM in other areas.

It is noteworthy that the proposed amendments also introduce a transition rule to ensure that the mean CIF for the first taxation year that begins after 2022 is calculated as if IFRS 17 had been in force in the immediately preceding year. Therefore, it requires insurers to recompute the CIF and other related components for a taxation year that ends before January 1, 2023 (i.e. 2022).

Transition

As expected, the transition year will be the first taxation year that begins after 2022, or 2023 for all regulated insurance companies in Canada, and the date at which transitional amounts are to be calculated for these companies is the end of the preceding year (i.e. December 31, 2022). The transition amounts, whether positive or negative, will then be gradually taken into taxable income over five years. 

Under the proposed legislation, the transitional tax rules that were enacted for the 2011 accounting changes were largely kept intact, but modified to capture the specific relevant aspects of IFRS 17. Aside from including additional defined terms to address IFRS 17 balances, the draft legislative proposals modify the existing legislation to make it apply to all insurers (and not only life insurance companies); it also makes references to the relevant rules and regulations under which allowable reserve deductions are made, adjusting them for the deferred policy acquisition costs change for non-life insurers noted above and excluding 90% of the CSM from the transitional amount computation when applicable. This clarifies a point of confusion that arose from the 2022 federal budget, which inferred that there would be no transition of the initial non-deductible component of CSM.

The draft legislative proposals also include transitional rules to address changes to financial asset characterization or measurement of revenue, gains or losses as a result of implementing IFRS 9; the proposed legislation is generally similar to the legislation for the mark-to-market regime change from 2006.

Part VI Financial Institutions Capital Tax

Consistent with the 2022 federal budget, the draft legislative proposals include measures that will require other comprehensive income and policyholder liabilities to be included when computing taxable capital, while also repealing the exclusion from taxable capital of deferred tax debit balances. The proposed legislation also includes accompanying changes to adjust for the items noted above, for instance, the manner in which policy reserves are to be calculated for tax purposes. 

Canada Recovery Dividend and Additional Tax on Banks and Life Insurers

The August 9, 2022 draft legislative proposals include legislation to implement the 2022 federal budget measures that will subject banks, life insurers and their related financial institutions to the following new taxes:  

• Canada Recovery Dividend – a one-time 15% tax that will apply on the average of taxable income for taxation years ending in 2020 and 2021 over $1 billion (shared among group members); the tax liability is imposed in the 2022 taxation year, but is payable in equal amounts over five years (i.e. included in the 2022 through 2026 federal tax filings), and the amount required to be payable for that year will reduce the Part VI Financial Institutions Capital Tax liability for that same year 
• Additional Tax on Banks and Life Insurers – a 1.5% tax that will apply on taxable income over $100 million (shared among group members), for taxation years ending after April 7, 2022 (pro-rated for a taxation year that includes April 7, 2022)

The draft legislative proposals clarify that insurers otherwise currently subject to Part VI capital tax (even when no Part VI tax is payable in a year) will be subject to these additional taxes. The draft legislative proposals also make corresponding changes to the interaction of Part I income tax and Part VI capital tax to reflect the potentially greater Part I income tax that will arise under the new regimes.

The takeaway

This comprehensive view of Finance’s policy direction with respect to the taxation of insurance contracts under IFRS 17 is welcome news to the insurance industry – particularly given the impending effective date. Although a more comprehensive review of the draft legislative proposals will be required to determine whether there are issues or details in the legislation that need to be clarified or potentially adjusted, the key areas described in this Tax Insights provides insurers with a tax framework that largely maintains the current scheme of the Income Tax Act. The framework, for the most part, also relies on using accounting income under IFRS 17 as the appropriate basis for determining income for tax purposes – a position Finance announced in its May 2021 backgrounder.

Insurers still face a significant amount of work to accommodate the changes to their tax reporting systems and processes, including the implementation of numerous changes to key tax compliance forms and returns, as well as the significant financial reporting challenges associated with implementing a new accounting standard and tax rules. Interested parties are asked to provide comments to Finance on the proposed legislation by September 30, 2022.