Tax, banks and life insurers

By Marjorie Tang and Paul Vienneau

As talks on financial deregulation heat up, the feds are under pressure to ensure the tax system is neutral across the sector

Canada’s top six banks (Bank of Nova Scotia, Bank of Montreal, CIBC, Royal Bank, National Bank and Toronto-Dominion Bank) and top three multinational life insurers (Great-West Life, Manulife Financial and Sun Life Financial) comprise more than 90% of the total assets of all Canadian banks and life insurers. While specific Canadian tax policies and related rules that apply to the banks and life insurers are not the same, the effective tax burden on each “pillar” is not significantly different. As the federal government considers whether any changes to the rules governing ownership of Canadian financial institutions would allow the “cross-pillar” merger of banks and insurers, taxation of these financial institutions should not have any significant influence on these discussions.

The Canadian tax system is based on a worldwide taxation regime under which Canadian residents are taxed on all income, regardless if it is earned in Canada or in a foreign country. Canadian residents who earn business or investment income from foreign sources must include that income in calculating income subject to tax in Canada even if that income is subject to tax in the country it originated. A foreign tax credit mechanism recognizes taxes paid to the foreign country and allows Canadians to claim a credit against taxes payable on that income in Canada.

Banks and life insurers are subject to the worldwide tax regime. How-ever, earnings of foreign subsidiaries that have an active business outside Canada are generally exempt from tax in Canada. (While there are some differences in the application of these rules to banks and insurers, discussion of the differences is beyond the scope here.) Since insurers have traditionally carried on foreign business through branches, special rules apply to the taxation of the insurance business income earned by the life insurers. That income is subject to a territorial regime of taxation.

Prior to 1968, life insurers were not subject to tax on their insurance business income. After 1968, new tax rules were adopted that brought the insurance business income of all life insurers in the realm of Canadian taxation. Canadian life insurers had been able to operate through foreign branches (as opposed to subsidiary companies) so that the financial strength of the entire life insurer was available to support the insurer’s future obligations to foreign policyholders. The Canadian life insurance industry was concerned that foreign policyholders and the insurers’ ability to market their products in foreign jurisdictions would have been negatively impacted if a worldwide taxation regime was adopted in Canada that subjected the profits allocated to foreign policyholders to Canadian tax rates. Therefore a territorial regime was adopted and provides that where a life insurer carries on an insurance business in Canada and elsewhere, only the income from Canadian insurance operations is subject to tax in Canada. Consequently, insurance business income generated from foreign branches generally is not included in the Canadian tax base. Note that insurers earn a higher percentage of their revenue outside Canada than do banks. (Almost 60% of total premium revenue of life insurers was earned outside Canada, while only about one-third of total revenue of banks was earned outside Canada based on information reported in the 2003 annual reports for these institutions.) As insurers transfer foreign branch operations to foreign subsidiary companies, the percentage of income earned from foreign branches decreases.

Generally only premiums and related income and expenses from life insurance policies issued to Canadian residents are included in computing the insurer’s taxable income from a Canadian insurance business. Because of the long-term nature of the insurance business, the tax rules provide a mechanism whereby an insurer is allowed a deduction in computing its income for Canadian tax purposes in respect of the reserves that it must hold to ensure funds will be available when future claims are made by its policyholders. The Canadian tax system contains a complicated set of rules that calculates the investment income of a life insurer that must be included in the Canadian tax base in respect of its Canadian insurance business. The life insurer is not allowed to claim a foreign tax credit in respect of any foreign taxes paid on any investment income.

The underlying tax policy of the territorial regime of taxation still appears to be supported by the Department of Finance. Following a court decision that  cast doubts as to whether the applicable tax rules in that decision supported the territorial regime, Finance later released proposed amendments to the Income Tax Act to preserve the territorial regime. As shown (see table on p. 43), this regime doesn’t appear to impact the tax burden on life insurers compared with banks.

Even though life insurers and banks are taxed under different regimes, the total income, capital and premium taxes as a percentage of income reported by the banks and the life insurers for their 2003 taxation years are very similar (see table on p. 43). Note that for life insurers, premium taxes account for a significant portion of these taxes. Premium taxes are levied on life insurance premiums by the various provinces instead of the applicable capital taxes that most of the provinces impose on the banks’ capital.

The table above compares the provincial capital tax and premium tax rates for life insurance. Premium taxes are imposed on life insurance premiums written in the particular province. Premiums are considered to be written in the province in which the policyholder is resident at the time the premium is payable.

The consolidation of the financial services industry in Canada has been the topic of much public discussion. In particular, the federal government has been asked to consider whether any changes that are made to the rules governing ownership of Canadian financial institutions would allow the cross-pillar merger of a bank and a life insurer. Currently, Canadian banks and life insurers with equity greater than $5 billion must be widely held.

Widely held Canadian banks and life insurers may be owned through a holding company structure. From a tax perspective, that structure would facilitate the common ownership of a bank and a life insurer and allow the separate companies to continue to exist. Canadian tax rules do not clearly contemplate the merger of a bank and a life insurer into a single corporation. The Income Tax Act defines a bank to be a bank according to the Canadian Bank Act, while an insurance corporation is defined as a corporation that carries on an insurance business. The unintended application of certain tax rules meant to apply solely to banks or insurers would create a lot of uncertainty. For example, tax rules used to compute the federal capital tax for a bank are different from those that apply to an insurance corporation. Similarly, tax rules that allocate income of a bank among the provinces aren’t the same as those that allocate income of an insurance corporation among the provinces.

In 1995, William Strain wrote that as financial deregulation continues in Canada, the government will come under increasing pressure to ensure the tax system is neutral across the financial services sector (“Taxation of Life Insurance,” [1995], vol. 43, no. 5 Canadian Tax Journal, 1506-1546). Based on the information in the table on p.43, while the tax regimes applied to banks and insurers may not be the same, the tax burden is not significantly different.