Last week’s budget nixed the tax advantages of a popular life insurance strategy.
A loophole in the tax act had allowed business owners to transfer their life insurance policies to their corporations in return for tax-free proceeds of the policy’s fair market value (FMV), usually in the form of a note. Then, when the business owner died, the corporation would receive the proceeds of the death benefit – again, essentially tax-free. Private corporations would then add the value of the benefit, less the adjusted cost basis, to their capital dividend accounts, and then pay out capital dividends, which aren’t taxable in the hands of shareholders.
The 2016 budget proposes to tax the initial transfer from the policyholder to the corporation as full income, says Kim Moody, director, Canadian Tax Advisory at Moodys Gartner Tax Law.
On his blog, Moody has written up an example to illustrate the changes being proposed.
He assumes the following facts:
- Mr. Apple is 75 years old and in poor health.
- Mr. Apple owns a T100 life insurance policy with a death benefit of $1 million. The cash surrender value of the policy is nil.
- The adjusted cost basis (ACB) of the insurance policy is nil.
- An actuary has recently valued Mr. Apple’s policy at $800,000.
- Mr. Apple is the sole shareholder of AppleCo, a Canadian-controlled private corporation.
- AppleCo has retained earnings in excess of $10 million.
Before Budget 2016
Before Budget 2016, if Apple transferred the life insurance policy to AppleCo for FMV consideration of $800,000 using a promissory note, Moody explains, that non-arm’s length transfer of the policy would not have triggered any taxable income inclusions since there is no cash surrender value (CSV) of the life insurance policy. Further, there was no specific rule that would have taxed the $800,000 of consideration received by Apple from AppleCo. “Thus, effectively, he [was] able to extract $800,000 from his corporation without tax,” Moody writes.
After Budget 2016
Assuming the proposals go through, if the transfer occurs after March 21, 2016, the $800,000 will be included in Apple’s proceeds of the disposition of the life insurance policy. Crucially, “Mr. Apple will now be required to pay income tax on such amounts received in excess of the ACB of the policy at normal rates.”
There’s more, says Moody. “In addition, for dispositions that occur on or after March 22, 2016, a new rule under paragraph 148(7)(b) will require the ACB of the insurance policy to be increased by the amount of the deemed proceeds received by Mr. Apple on the transfer. Given that the ACB has been increased, the capital dividend account addition for AppleCo will be reduced upon Mr. Apple’s death — thus reducing the amount of funds that can otherwise be extracted from AppleCo tax-free. Ouch!”
Moody explains that policyholders who made these transfers before Budget Day and die after Budget Day are also affected. “Proposed amendments to the definition of ‘capital dividend account’ will require a reduction of the CDA by the $800,000 (since the $800,000 is in excess of the CSV of the policy),” he writes. What does that mean? “This, in effect, [retroactively] punishes policy transfers prior to March 22, 2016, since the ability to extract the life insurance proceeds from AppleCo will now be reduced by the value of the consideration received in excess of the CSV of the policy disposed.”