Medical advances have improved the survival rates of people diagnosed with critical illnesses such as cancer, stroke and heart disease. But recovery can come at a significant financial expense, particularly for business owners who may need to pay for their treatment costs and ensure their company continues to function.
In this article, Stuart Dollar, Director, Tax and Insurance Planning, Individual Insurance and Wealth, discusses how shared benefit of a critical illness insurance (CII) policy works and what you need to be aware of before considering such an arrangement. He also discusses how this strategy can be positioned as key person insurance and a retirement benefit for employees and business owners. [Tweet this].
How might a corporation use a CII policy to provide key person insurance and potentially help the shareholder with their retirement?
Let’s say a business has a key employee, and they want to provide a benefit that encourages this person to stay with them, while also providing value for that key person. A business could do that using a CII policy with a shared benefit.
The parties would draft a contractual document with the help of their own individual legal representatives. The key employee would own a CII policy. The employee would name themselves as a beneficiary for part of the CII health benefit, with the employer named as an irrevocable beneficiary for the rest. The employer would pay all the premiums. The employer could not deduct that part of the premiums paying for the employer’s CII benefit, nor would those premiums be a taxable benefit to the employee. The part of the premiums paying for the employee’s benefit would be a taxable benefit to the employee, and, if those premiums were deemed a reasonable business expense, would be deductible to the employer.
What happens if the employee decides to leave?
The employer’s irrevocable beneficiary designation serves as a golden handcuff during the employee’s working years. If the employee leaves, they could keep their policy, but the employer would remain as an irrevocable beneficiary. The employee would now have to pay all the premiums to keep the policy in force, and the employer wouldn’t have to contribute. If the employee had a covered critical illness, part of the CII benefit would go to the employer.
There’s no requirement that the employer maintain the irrevocable beneficiary designation for any specific period of time. The employer could agree that past a certain point, five years for example, it would remove itself as an irrevocable beneficiary if the employee resigned. In that sense, the benefit has a vesting period. As long as the employee agreed to stay for at least five years, they could have the right to name themselves as the beneficiary for the entire CII benefit if they left.
There’s nothing in the Income Tax Act (ITA) or Canada Revenue Agency (CRA) guidance that describes the tax consequences that would flow from the employer releasing its irrevocable beneficiary designation. It’s possible that the CRA would regard the release as a transfer of the employer’s interest in the policy, and treat the release as a taxable employee benefit. The parties would need to discuss that event with their independent tax advisors, and would need to retain an independent actuary to value the interest in the policy that the employer was transferring.
What happens at the employee’s retirement?
The parties’ agreement would have to included what happens when the employee retires. One option would be to treat retirement the same as resignation: the employer would let the employee name a beneficiary for the entire CII benefit.
The advantages to the employee are that the employee adds the employer’s coverage to their own, and pays for their CII coverage using rates that were established when the employee was younger. The drawbacks are that the release of the employer’s irrevocable beneficiary designation would likely be a taxable benefit, and the employee would have to continue paying premiums in retirement.
How could the employer and employee address those drawbacks?
The parties could address the two drawbacks by choosing a CII policy with an accelerated premium feature, one that would be fully paid up before retirement, in 10 or 15 years, for example.
For more information on CII, visit the updated Canadian Health Insurance Tax Guide.
At the emplyee’s retirement, the employer would have to actively withdraw their interest in the policy by filing a written record with the insurer’s principal head office. This would ensure the employer was named as an irrevocable beneficiary for part of the policy, but only until the employee’s retirement. The employee would own the entire policy, and would be a beneficiary for part of the CII coverage during their working years, and for all of the CII coverage from retirement going forward.
As above, the employer would pay all the premiums, and the employee would have to treat the premiums relating to the employee’s coverage as a taxable benefit. The employer would be able to deduct the premiums paid for the employee’s coverage, provided they were a reasonable business expense, but could not deduct the premiums paid for the employer’s benefit.
How could the parties value their respective interests in the policy?
The parties would need independent tax advice on this point. One way would be to say that the cost of the employer’s coverage was equivalent to the cost for term insurance in the same coverage amount. For example, if the employer was a beneficiary for $100,000 worth of CII coverage under a policy that would be paid up in 10 years, and if the employee was retiring in 10 years, the employer would not be able to deduct an amount equal to the premiums it would pay for the same amount of coverage under a 10-year term CII policy. The rest of the premiums would be deductible and would be a taxable benefit for the employee to the extent they were a reasonable business expense.
At retirement, it’s arguable that the CRA would not see the employer’s release of its irrevocable beneficiary designation as a taxable employee benefit: the employee would have already paid for a fully paid up policy during their working years by having to include in income the extra premiums that the employer had paid for that benefit.
Using a paid up policy addresses the two drawbacks – the employee won’t have to pay premiums for CII coverage in retirement and (subject to the opinions of the parties’ tax advisors) won’t have to pay tax on the employer’s release of the irrevocable beneficiary designation. But using a paid up policy is more expensive during the employee’s working years. On the other hand, the employee is in a better position to bear that expense while working, and the employer could pay a bonus to help offset the added cost for the employee. Of course, the bonus would be taxable, too. Otherwise, there’s nothing to be done about the last point, except evaluate whether the extra cost for the arrangement is worth the added benefits.
Could the parties add a return of premium at cancellation or expiry (ROPC/E) benefit?
The employee may not want the extra CII coverage that comes from the employer releasing their interest in the policy at the employee’s retirement. They may want a sum of money instead. Adding the ROPc/e benefit gives the employee some flexibility in retirement to cancel all or some of their coverage for a return of premium. For example, the employee could surrender the CII coverage equal to the employer’s coverage for a partial return of premiums.
Here’s how this part of the concept could work: The employee would apply to add the ROPc/e benefit to the policy when they applied for coverage. The parties’ agreement would say that the employee would own the ROPc/e benefit, and that the employer would have a right to some of the CII coverage only during the employee’s working years, the same as if there were no ROPc/e benefit. The employee would have the right to all other policy benefits, and would include the premiums associated with those rights in income. The employer would pay all the premiums, CII and ROPc/e, and would be able to deduct those premiums (except the premiums for the employer’s coverage), as long as they were a reasonable business expense.
At retirement, or at any time after retirement, the employee could cancel coverage (provided at least 15 years had passed and no claim had been made under the policy) in full or in part, for a full or partial refund of premiums. The ITA does not describe the tax consequences associated with an ROPc/e benefit, but the CRA has said that the ROP benefit should be tax-free provided the premiums have been paid with after-tax money (CRA Document 2002-0117495, March 4, 2002). The CRA’s guidance deals with disability insurance, but the reasoning should also apply to CII.
Implicit in the CRA’s reasoning is the assumption that the ROPc/e benefit is only tax-free if the recipient has paid all the premiums using their own after-tax money. That assumption applies if the employee pays the premiums from their own after-tax money, or if they treat the employer’s premium payments as a taxable benefit. The CRA’s reasoning appears to be that if you paid all the premiums using after-tax money, and you’re getting back only the premiums you paid, you shouldn’t have to pay tax on what you get back.
This reasoning should apply to all the premiums the employee had to include in income, but not to the premiums the employer paid. It’s likely that the part of the ROPc/e benefit equal to the premiums the employer paid would be treated as a taxable benefit to the employee. The parties could deal with that question in one of two ways. The employee could agree to pay the employer for the value of the benefit at retirement. In this case, the parties would need to retain an independent actuary to help them determine the value of that benefit. Or the employee could accept that if they cancelled coverage, the part of the ROPc/e benefit equal to the employer’s premiums would be taxable.
As with all things tax-related, the parties would have to consult with their own independent tax advisors regarding the tax treatment of their agreement, and specifically the ROPc/e benefit.[Tweet this].
Are there any other ways to enhance the value of a shared benefit CII arrangement?
Another way to enhance the value of this arrangement for the employee is to add a long-term care conversion option (LTCCO). This benefit lets the policy owner convert all or part of their CII coverage to long-term care insurance (LTCI) without further evidence of insurability. The conversion option may be exercised in whole or in part at any time between the policy anniversaries nearest the policy owner’s 60th and 65th birthdays.
The parties could add the LTCCO benefit with or without the ROPc/e benefit, but we’ll assume for present purposes that they are adding it to a policy with the ROPc/e benefit.
A note on shareholder employees
Many owners of their own corporations are also employed by those corporations. But the CRA treats what they receive from their corporations as shareholder benefits – paid because they own the corporation and can significantly influence corporate policy, not because they are employed by the corporation. Shareholder benefits are not deductible to the corporation, and are taxed to the shareholder at their top marginal rate. For the corporation to deduct the payment, it has to show that the shareholder receives their benefit as an employee, not as a shareholder, and that the expense is a reasonable business expense. The parties should speak with their independent tax advisors on how best to ensure that the CRA agrees that any benefits paid under a shared benefit CII arrangement are employee, not shareholder, benefits.
A conversion is treated as a partial cancellation of CII coverage, generating a partial payment of the ROPc/e benefit. As discussed above, part of the ROPc/e benefit would likely be taxed, unless they were otherwise accounted for. Although LTCI policy premiums would be due on the LTCI coverage, the ROPc/e benefit could be invested or used to buy a life annuity. The after-tax income could help offset the premium cost for the LTCI policy. Annuity income would continue even if the employee needed long-term care and went on claim. Investment income would also continue, subject to investment returns and the amount of income taken from the investment.
An example of how the shared benefit CII concept might work
Let’s assume that the employee owns a $250,000 CII policy with the ROPc/e and LTCCO benefits, and that the employer is an irrevocable beneficiary for $100,000 of that coverage until the employee’s retirement, 10 years from now. At that time coverage will be paid up, the agreement will end, and the employee will own the entire policy. The employer could say that its share of the premium cost should be the amount it would have to pay for $100,000 of CII coverage (without the ROPc/e or LTCCO benefits) using a 10-year term CII policy.
The employer could not deduct the premiums for its share of the coverage, and those premiums would not be a taxable benefit to the employee. The rest of the premiums, including the ROPc/e and LTCCO benefit premiums, would be a taxable benefit for the employee, and deductible to the employer if they were a reasonable business expense.
It’s useful to think of the employee as receiving several distinct taxable benefits during their working years and at retirement:
- $150,000 in CII term insurance coverage while employed
- $250,000 in paid up CII coverage at retirement
- the ROPc/e benefit for the $250,000 in coverage after the policy has been in force for 15 years
- the LTCCO benefit, allowing a conversion of all or part of the CII policy to LTCI during the contractually established window
The employee would have to include the premium cost associated with these benefits as income. Essentially, the entire premium cost, except the employer’s cost for the equivalent of a 10-year term $100,000 CII policy, would have to be treated as income by the employee.
If the employee had a covered critical illness during their working years, the policy would end, and each party would get their respective CII benefits tax-free: $150,000 to the employee and $100,000 to the employer. There would be nothing paid in respect of the ROPc/e or LTCCO benefits.
But if the employee reached retirement age in good health, they would then own a $250,000 CII policy with no obligation to pay any more CII premiums. If the employee’s intention was to maintain CII coverage, there would be no tax consequences at or during the employee’s retirement. If the employee had a covered critical illness, they would get the benefit tax-free.
Between the policy anniversaries nearest the employee’s 60th and 65th birthdays, they could convert some or all of the CII policy to LTCI. The conversion would be treated as a full or partial surrender, and trigger payment of some or all of the ROPc/e benefit. Some of that ROPc/e benefit likely would be taxable to the employee, unless the employee had dealt with the tax consequences at retirement. The employee could use the ROPc/e benefit to help pay for the LTCI premiums, either by investing the benefit or by using it to buy a life annuity. Life annuity income would be guaranteed, but whether the investment income lasts would depend on the nature of the investments chosen and the level of income taken. It’s important to remember that LTCI premiums are not guaranteed never to rise. The employee would need to check the terms of the individual policy for further details.
If the employee needed LTCI at some point, the benefit would be tax-free, and the annuity or investment income would continue, subject to the investment’s assets sustaining the chosen level of income. The employee’s CII coverage would also continue, subject to the policy’s terms, even if the employee was claiming LTCI benefits.
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This article is intended for information purposes only. Sun Life Assurance Company of Canada has not been engaged for the purpose of providing legal, accounting, taxation, or other professional advice. No one should act upon the examples/information without a thorough examination of the legal/tax situation with their own professional advisor, after the facts of the specific case are considered.
Stuart Dollar is Director, Tax and Insurance Planning, at Sun Life Financial. He began his financial services career in 1994 as a retirement planner with London Life. Over his career, he has worked in management, as an advisor, and, from 2002 to 2009, as an advanced marketing attorney for Genworth Financial in the United States. Stuart returned to Canada in 2009 to join Sun Life Financial. He helps brokers and agents with tax issues related to life and health insurance, and wealth products. He has extensive knowledge regarding the taxation of life and health insurance policies, annuities, segregated funds and mutual funds. He is also experienced in the taxation of U.S. life and health insurance policies, annuities and mutual funds, as well as U.S. income, gift and estate tax law. Stuart is a frequent speaker at industry events, and has authored several articles, including the Canadian Health Insurance Tax Guide and Strategies for Canadians with U.S. Retirement Plans.