Last month’s Retirement Resource Centre article, Life insurance transfers and taxes – part 1, explored the tax implications of policy transfers between individuals and within families. This article — the second in a 2-part series — focuses on transfers involving corporate-owned life insurance policies.
Note: Throughout this article, references to specific legislative provisions are from the Income Tax Act (ITA), unless otherwise indicated.
It’s not uncommon for corporations to own life insurance policies for shareholders or key employees. And when circumstances change (due to new ownership, restructuring, a retirement or other business activity), these policies may change hands. The resulting tax implications will depend on the nature of the transfer and other details, as these 4 examples — all based on the following information — demonstrate:
- Policy owner: XYZ Inc.
- Life insured: Ms. Smith
- Policy type: Permanent life insurance
- Insurance amount: $1,000,000
- Cash surrender value (CSV): $100,000
- Adjusted cost basis (ACB): $65,000
- Fair market value (FMV): $500,000
#1 – CORPORATION TO SHAREHOLDER/EMPLOYEE (NON-ARM’S LENGTH)
There are 2 components to consider here. First, the transfer of the policy will trigger a taxable gain to the original owner — the corporation. And as a shareholder/employee, Ms. Smith will receive a taxable shareholder/employee benefit.
No matter how much Ms. Smith pays XYZ Inc. in exchange for the policy, the taxable policy gain will be based on the policy’s CSV of $100,000. The tax impact for XYZ Inc. is as follows:
Proceeds of disposition1 – ACB = Taxable policy gain
$100,000 – $65,000 = $35,000
And when Ms. Smith acquires her interest, she pays XYZ Inc. $100,000. Because the policy’s FMV is higher than what she paid, the tax impact for her is as follows:
FMV – amount paid = Taxable benefit
$500,000 – $100,000 = $400,000
According to the Canada Revenue Agency (CRA), a shareholder or employee must include a taxable benefit in their income (under the provisions of subsection 15(1) or paragraph 6(1)(a)) for the year the transfer takes place. This taxable benefit:
- is usually equal to the difference between the policy’s FMV and the amount paid,2 and
- must be included in the shareholder or employee’s taxable income.3
To prevent a taxable benefit, the shareholder or employee must pay the corporation an amount equal to the FMV of the policy.
Arm’s length transactions – ‘Arm’s length’ transactions involve people who aren’t related to each other. The taxable income resulting from a disposition can differ depending on the type of transaction and if clients are dealing at arm’s length.
When clients deal at arm’s length, the provisions of subsection 148(1) and the definition of ‘proceeds of the disposition’ in subsection 148(9) will apply. The disposition price is the amount that was ‘paid’ and that the policy owner is entitled to receive.
Non-arm’s length transactions – ‘Non-arm’s length’ are transactions involving blood relatives, married couples (including common-law and same-sex partnerships) and adopted children. Non-arm’s length relationships may also exist between an individual and a corporation, a trust or two corporations.
#2 – OPERATING COMPANY TO HOLDING COMPANY
Corporate restructuring or the sale of an operating company often leads to changes in ownership structure of life insurance policies. When an operating company is owned by a holding company, it’s common for the operating company to transfer ownership of a policy to the holding company. The provisions of subsection 148(7) apply.
The tax effects of this type of transfer depend on how much the holding company pays to the operating company for the policy, as demonstrated in these scenarios.
|Scenario 1||Scenario 2||Scenario 3|
|Operating company||Amount paid by holding company to operating company||Nil||$100,000 (CSV)||$500,000 (FMV)|
|Proceeds of disposition||$100,000||$100,000||$100,000|
|Taxable policy gain||$35,000||$35,000||$35,000|
|Holding company||Taxable benefit||$500,000||$400,000||Nil|
The holding company could negate the taxable benefit by ensuring the amount paid reflects the FMV of the policy and by declaring a dividend equal to the FMV of the policy ($500,000). The dividend could be treated as an inter-corporate dividend in kind. Interpretation Bulletin IT-67R3, Taxable dividends from corporations resident in Canada, explains the tax treatment of dividends in kind. According to this bulletin, the dividend would be equal to the policy’s FMV even though the proceeds of the transfer and new ACB correspond to the policy’s CSV. However, if the dividend in kind is declared and paid before the sale of shares of the transferring corporation, subsection 55(2) may apply, deeming the tax-free inter-corporate dividend as a taxable capital gain.
#3 – TRANSFERS BETWEEN SISTER CORPORATIONS
In a corporate restructuring, transferring a life insurance policy from one sister corporation to another may be a good idea. This type of transaction falls under the provisions of subsection 148(7).
Consider a situation where XYZ Inc. owns an insurance policy on the life of a shareholder who’s also a shareholder of DEF Inc. After restructuring the business, XYZ Inc. decides to transfer this policy to DEF Inc. The tax effects of this type of transfer depend on how much DEF Inc. pays XYZ Inc., as shown by these scenarios.
|Scenario 1||Scenario 2||Scenario 3|
|XYZ Inc.||Proceeds of disposition||$100,000||$100,000||$100,000|
|Taxable policy gain||$35,000||$35,000||$35,000|
|DEF Inc.||Amount paid by DEF Inc. to XYZ Inc.||Nil||$100,000 (CSV)||$500,000 (CSV)|
In this example, the two corporations aren’t shareholders of one another. As a result, there can be no taxable benefit for the transferring corporation under subsection 15(1). The CRA does, however, indicate that subsection 15(1) may apply if:
- the transferring corporation experiences impoverishment (depletion of assets) due to the transfer, and
- the transfer resulted in an economic benefit for a sole shareholder of the two corporations.4
#4 – SHAREHOLDER TO CORPORATION
For estate planning purposes or as a result of corporate restructuring, a shareholder may wish to transfer their personally-owned life insurance policy to a corporation they control. The shareholder and their corporation would not deal at arm’s length, and subsection 148(7) applies. In this case, the shareholder (transferor) is deemed to have disposed of their policy for proceeds of disposition equal to the CSV. They’ll have to include the policy gain in their taxable income for the year, equal to the proceeds of disposition, minus the ACB of the policy.
In addition, if the shareholder can demonstrate that the FMV of the policy is greater than its CSV, they can receive a payment equal to this FMV from the corporation on a tax-free basis. As long as the amount paid doesn’t exceed the policy’s FMV, the shareholder won’t incur a taxable benefit. This transaction will, however, require an independent valuation by a tax professional to determine the FMV of the policy before proceeding with the transfer.5
This table shows the tax implications of this type of transfer:
|Proceeds of disposition||$100,000|
|Taxable policy gain||$35,000|
|Tax (assumed at 45%)||$15,750|
|Net amount received||$484,250|
The transferring company will also be entitled to a credit to its capital dividend account (CDA) on payment of the death benefit, assuming it’s the beneficiary of the policy. The credit to the CDA is equal to the death benefit minus the ACB of the policy.6 For more details on this strategy, see Transferring a life insurance policy to a corporation on the tax and legal section of the Sun Life Financial advisor website.
The new ACB of the policy for the corporation remains equal to the policy’s CSV (not its FMV). This lower ACB will increase the policy gains that may occur in the future if it’s cashed in during the insured’s lifetime. In return, it may also constitute a benefit, as the credit to the CDA upon the insured’s death will also be higher.
Transfers and amalgamations
When 2 or more corporations amalgamate and the provisions of section 87 apply, the new corporation is considered to be the same corporation for each amalgamated corporation. As a result, the tax characteristics of a life insurance policy continue to apply.7 This type of transaction isn’t a disposition since the new company is simply a continuation of the original, amalgamated corporations.
Transfers and corporate wind-ups
When a corporation winds up and the parent company absorbs any subsidiaries, the parent corporation, in respect of each subsidiary, is considered to be the same corporation. This means the parent company is a continuation of the original, under subsection 88(1). If the applicable tax rules are followed, the life insurance policy could be transferred tax free and the policy’s ACB would remain the same.8
Determining the FMV of a life insurance policy
As the examples throughout this article show, transfers often require an assessment of a policy’s FMV. This value will depend on several factors and won’t necessarily correspond to a policy’s CSV. CRA Information Circular 89-3, Policy Statement on Business Equity Valuations, outlines certain valuation principles. According to these principles, factors to consider in correctly determining the FMV of a policy include:
- the policy’s CSV and face value,
- the state of health, insurability and life expectancy of the insured,
- conversion privileges, riders and other provisions, and
- the replacement value and type of policy involved.
To determine a policy’s FMV, always consult a qualified actuary. Life insurance companies don’t provide this service so clients will usually need to engage the services of an actuarial consulting firm.
BEFORE A TRANSFER
The tax implications of life insurance policy transfers can be complicated and difficult to assess. Before proceeding with a transfer, encourage clients to talk with their tax and legal advisors.
You can also learn more. Tax implications when transferring ownership of a life insurance policy, published in May 2015 by Sun Life Financial (authored by Jean Turcotte, B.A.A., LL.B., Director Tax, Wealth and Insurance Planning Group), includes more detail.
1 The ITA defines the transfer of ownership of an interest in a life insurance policy as a ‘disposition’.
2 Confirmed by the Canada Revenue Agency (CRA) technical interpretation 9831355F dated January 4, 1999
3 Confirmed by the CRA technical interpretation 9327305 dated January 13, 1994
4 Round Table – Taxation of Financial Strategies and Instruments, 2006 APFF Convention, Montreal, October 2006, Question 15; Tax Window Files, October 6, 2006, number 2006-0197211C6
5 In the technical interpretation 2003-0040145, a similar scenario was provided to the CRA for comments. The CRA agreed with the tax results. In a more recent technical interpretation (2008-0303971E5 dated May 27, 2009), the CRA was again asked for its comments on the transfer of an insurance policy by an individual to his wholly-owned corporation. The CRA stated that the “situation you have described in your request has, in fact, been brought to the attention of the Minister of Finance.”
6 Paragraph 89(1)(d) ITA
7 CRA Interpretation Bulletin IT-474R, Amalgamation of Canadian Corporations, March 14, 1986; technical interpretation 9211260, CALU, May 11, 1992
8 Confirmed by technical interpretation 2005-00116631C6