When a shareholder borrows using her company assets as collateral, this can create a taxable benefit. But for how much?
In the case Golini v The Queen (2016 TCC 174), the shareholder did not pay enough for the benefit he received.
In Golini, the Tax Court found that Paul Golini received an immediate shareholder benefit when he used his corporation’s assets (a life insurance policy and an annuity contract) as security to borrow personally, and that he didn’t pay enough to his company for this. He had to pay tax on what that benefit was worth – a lot more than the guarantee fee he paid to his company. But the court did permit Golini to deduct out-of-pocket interest paid on the borrowing.
Here are the basic facts.
- Golini owned preference shares of OInc.
- Golini incorporated Holdco and a reorganization was done. After the reorganization, Golini held shares in OInc and Holdco. Holdco, in turn, also held shares of OInc.
- OInc obtained a $6-million bridge loan from an offshore bank, and used the loan to buy Holdco’s shares of OInc back for $6 million.
- Holdco took the $6 million in proceeds and bought an annuity from an offshore insurer. That annuity paid $400,000 per year to Holdco for 15 years or until Golini’s death.
- The annuity payments were used to pay annual premiums of $400,000 on a life insurance policy, issued by another offshore insurer, owned by Holdco on the life of Golini. The death benefit was $6 million.
- The offshore insurers reinsured the annuity and the life insurance such that the reinsurer (also offshore) stepped into their shoes. The reinsurer received $6 million.
- The reinsurer invested $6 million at 8% in another offshore lender that loaned $6 million to Canco (unrelated to Golini) at 8%.
- Canco loaned $6 million to Golini at 8%.
- Golini bought $6 million worth of high paid-up capital (PUC) shares in OInc, with a cumulative dividend entitlement of 8.25%.
- OInc repaid the bridge loan with the $6 million paid by Golini for the high PUC shares.
- Holdco provided Canco with a collateral assignment of the annuity and the life insurance policy as security for the loan to Golini, limiting Canco’s recourse for repayment of the loan to realization of that collateral only.
- Golini paid an annual guarantee fee of $40,000 to Holdco and deducted the fee and 8% annual interest (approximately $480,000) on the borrowing from his income in the year. Golini paid $80,000 of the interest in cash; the rest was capitalized and added to the loan amount.
- The death benefit under the life insurance policy was increased each year by the capitalized interest.
- At death, the loan and capitalized interest was to be offset by the life insurance death benefit.
The upshot: thanks to this convoluted structure, Golini borrowed at 8% and deducted that 8% interest from his income, while only being out-of-pocket $80,000, thus lowering his taxable income. He also received a $6-million loan without having to provide personal collateral for the cost of the $40,000 annual guarantee fee and held a $6 million asset (the high PUC OInc shares). In the end, Holdco would never have to pay the $6 million loan back because the lender’s recourse was limited to the life insurance and annuity.
CRA reassessed Golini, and included a dividend in his income for the loan amount of $6 million, grossed up to $7.5 million. CRA also denied interest deductibility on the part of the loan that was capitalized.
The Tax Court judge found that Golini received a shareholder benefit under subsection 15(1) of the Act. Some choice quotes from the ruling:
- “Holdco obliged itself to pay [Golini’s] loan, including capitalized interest, through the assignment of the annuity and insurance proceeds.”
- “…in its simplest terms, immediate access to $6 million tax-free [via the loan] with only the obligation of a guarantee fee of $40,000 for 15 years, is a benefit arising from [Golini’s] position as a shareholder, and a benefit conferred by Holdco, given the inadequacy of the guarantee fee and the forgoing by Holdco of retaining the insurance proceeds.” (In other words, the $40,000 annual cost was not enough to pay for getting $6 million tax-free.)
- “Everyone’s understanding was the annuity and the insurance were the only manner in which the obligation of the [Canco] loan would be met.”
- “[Golini] does not have to repay the loan and therefore has an immediate benefit from the receipt of $6 million used to acquire the OInc shares.”
- “The payments of $40,000 a year to a maximum of 15 years do not constitute full consideration for obtaining immediate access to $6 million tax-free.”
- “Holdco has agreed to use insurance proceeds from a policy it owns to pay off its shareholder’s debt. [Golini] relies on the fact that Holdco remains a beneficiary of the insurance proceeds. I rely on the fact that Holdco has obligated itself to pay insurance proceeds to pay off the shareholder debt.”
Having found there to be a shareholder benefit, the judge went on to discuss the value of the benefit that should be included in Golini’s income. The Minister of Revenue argued for $6 million (the amount of the loan), while Golini argued it should be a reasonable commercial guarantee fee (without providing any expert evidence of what that might be) less the $40,000 paid as a guarantee fee to Holdco.
The judge accepted the expert evidence of a valuation professional for the value of the benefit, and that turned out to be the difference between the guarantee fee ($40,000 per year for 15 years) and the cost of the insurance premiums ($400,000 per year for 15 years). That works out to $360,000*15 = $5.4 million. The judge ordered that amount to be included as a shareholder benefit in Golini’s income in one lump sum in the year, meaning he would have to pay tax on it.
But since the CRA had previously reassessed Golini as having received a dividend ($7.5 million at dividend rates) and disallowed the interest deduction on the capitalized part of the loan, the amount of tax Golini owed was actually less than what the judge wanted to include in Golini’s income as a shareholder benefit: $5.4 million at ordinary income rates minus an interest deduction for the amount of interest actually paid.
Since the Tax Court can’t increase the amount of tax assessed, the reassessed amount is what Golini owes.
What this all means
This is an ugly fact pattern, and the judge agreed that “the transactions before me are not typical of products offered at the time. They are unique and are to be analyzed, I suggest, as a one-of-a-kind.”
Yet there is something to be learned from this case.
First, it raises several questions: Can this valuation metric be more broadly applied to other shareholder borrowing situations? Golini and Holdco were not on the hook for the $6 million because the lender only had recourse to the policy and the annuity, so does that fact make this valuation metric only applicable to this case?
And the crucial question: What is the value of the benefit when a shareholder borrows against his corporation’s assets? This question should be considered no matter what format the shareholder borrowing takes: whether through Leveraged Insured Annuities, 10/8s, 6/4s, Immediate Finance Arrangements, or Corporate Insured Retirement Programs.
My takeaway is that in the worst case scenario based on this case, the CRA may argue for an income inclusion in other situations that is determined by subtracting any guarantee fee from the premiums paid by the corporation.
The Court states that the guarantee fee was insufficient compensation for having access to tax-free cash in the form of a loan – a loan that, in this case, was pre-ordained to be repaid with the life insurance.
In short, advisors should be cautious recommending that clients use their company’s insurance policy as collateral for personal borrowing. Professional tax advice is a must.