When are dividends paid from a participating policy considered taxable?

Dividends paid from a participating policy are considered taxable when they exceed the total amount of premiums paid for that policy. This situation arises because dividends are a return of surplus generated by the insurance company's operations and are intended to distribute profits to policyholders. When the total dividends received by the policyholder surpass the amount they have paid in premiums, the excess is treated as taxable income.

In essence, the tax treatment hinges on the principle that any amount received that is beyond what the policyholder has contributed (in terms of premiums) is viewed as a gain rather than a return of their own money. Since the premiums represent the policyholder's investment in the policy, they are not taxable. However, any additional amounts received, which the policyholder has not directly paid through premiums, must be reported as income.

This understanding clarifies why the other scenarios, such as the policy lapsing, partial refunds of premiums, or reinvestment of the dividends, would not trigger taxable events in the same manner, as they do not result in a gain that exceeds the premiums paid.