The 2016 federal budget announced changes impacting the Capital Dividend Account (CDA) and the tax consequences of transfers of life insurance policies to a corporation. These changes address issues that have been on CRA and the Department of Finance’s radar for quite some time.
Prior to amendments proposed by the budget, the death benefit of a life insurance policy received by a private corporation, minus the ACB of the policy to the corporation was credited to a private corporation’s CDA. Capital dividends can be paid by the corporation tax-free to shareholders to the extent of its CDA balance.
Some taxpayers arranged their affairs so that one corporation owned a policy, and a different corporation was the beneficiary. This allowed for a full CDA credit for the life insurance proceeds because the beneficiary corporation did not have an ACB in the policy.
As far back as the mid-1990s, CRA acknowledged this was how it worked, but the agency also said that the general anti-avoidance rule could apply if the objective of separating ownership and beneficiary of a policy was to maximize CDA.
There are valid business reasons to name a different corporation as a beneficiary under a life insurance policy. One is creditor protection. Another is to facilitate a buy-sell agreement while holding a policy in a holding company so that if the underlying operating company is sold, the policy doesn’t need to be transferred.
These reasons were discussed in a 2013 Conference for Advanced Life Underwriting (CALU) submission to the Department of Finance, which recommended that the CDA definition be amended so that the policy’s ACB would be attributed to the beneficiary of the insurance proceeds. The submission asked that the recommended rule only apply to designations made after the effective date of any new definition.
This year’s federal budget proposes that for deaths on or after March 22, 2016, the credit to the CDA be reduced by the ACB of the policy, regardless of who owns the policy. This is achieved by reducing the CDA credit by the ACB of “a policyholder’s interest in the policy.” (The current language reduces the CDA credit by the ACB of “the policy to the corporation.”) A similar mechanism exists for partnerships and an equivalent amendment will apply the change for those structures.
One side effect of the wording change is that it could impose a double CDA grind in “split dollar” situations. A split dollar arrangement is commonly used where two parties jointly own a policy and agree to share the costs and benefits of the policy. Often, one party would pay for and be entitled to receive a certain amount of death benefit, while the other would pay for and be entitled to receive the cash value. The use of “a policyholder’s interest” instead of “the policyholder’s interest” appears to cause both the party entitled to the cash value on death and the party entitled to the death benefit to get a CDA grind for the ACB of the policy. It is unclear if this was Finance’s intention.
As an enforcement mechanism, the budget also proposes the introduction of an information-reporting requirement that will apply where “a corporation or partnership is not a policyholder but is entitled to receive a policy benefit.” Over the years, CRA has not only objected to having a different owner and beneficiary corporation for CDA reasons alone; it also raised potential benefit issues which might arise for such structures. Information reporting will enable the CRA to find these situations now, and not just at the time of death when a CDA calculation is made.
Another longstanding issue addressed by the budget is the tax consequences of a transfer of a life insurance policy from a shareholder to a corporation. Prior to the budget, the corporation could pay Fair Market Value (FMV) to the shareholder on the transfer with no shareholder benefit arising. At the same time, any taxable policy gain on the transfer being calculated is based on the policy’s “value,” which, under subsection 148(9) of the Income Tax Act, is defined as the cash surrender value (CSV); if there’s no CSV, the value is nil. For example, a $500,000 Term-to-100 policy with a CSV and ACB of $0 and a FMV of $100,000 could have been transferred tax-free to the corporation for $100,000. The benefits:
- no gain reported on the transfer;
- $100,000 consideration received tax-free; and
- the ACB to the corporation after the transfer is $0.
CRA again acknowledged this result in prior commentary and referred the matter to Finance.
The budget proposes that for transfers on or after March 22, 2016, the proceeds received on such a transfer are deemed to be equal to the total of the “value” plus the amount by which the FMV consideration given exceeds the value. So, in our example, the taxable policy gain would be calculated using $100,000 as the proceeds of the disposition resulting in the transferor including that amount in ordinary income, since the ACB is nil. The corporation would then have an ACB in the policy of $100,000.
Also, for any transfer prior to March 22, 2016, the budget proposes that the proceeds received over the value of the policy (“the excess”) reduce the CDA credit to the corporation where a death occurs on or after March 22, 2016. So, in our example, the excess of $100,000 would reduce the CDA to the corporation. It is important to note that this is a reduction that will occur on death and is not dependent upon whether the policy has an ACB. Rather, if there is an ACB at that time, it too will reduce the CDA credit along with the amount of the excess.
Similar changes are proposed to prevent this planning in the partnership context.
From a tax policy perspective, what Finance has done hangs together. Essentially, the government is not making something taxable that wasn’t already extracted tax-free. By extracting it during life, the excess is being taken out early. This measure simply prevents that excess from being taken out again, at death, on a tax-free basis. The $100,000 paid by the corporation in our example would have been left inside the company if the transfer never occurred and could not have been paid out without dividend tax being payable (assuming no pipeline planning).