Critical illness insurance has one very important difference from 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 payout. 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.