Policy Ownership

Plan accordingly to minimize tax

by Glenn Stephens & Kevin Wark, June 2008

A key aspect of insurance planning in the corporate market is the determination of whether an insurance policy should be owned by an individual shareholder, a holding company or an operating company. It is important to have ownership established properly from the beginning to avoid the potentially negative tax consequences of changing ownership in the future.

TRANSFERS FROM A CORPORATION TO AN INDIVIDUAL SHAREHOLDER

Where a corporation transfers a life insurance policy to an individual shareholder, it is deemed to have disposed of the policy for consideration equal to its "value" as defined in the Income Tax Act (the Act). "Value" for these purposes means cash surrender value (CSV). The actual amount paid by the shareholder, if any, is irrelevant for these purposes. Where the policy's CSV exceeds its adjusted cost basis (ACB), the excess is fully taxable to the corporation.

If the fair market value of the policy exceeds the consideration paid by the individual shareholder, a taxable shareholder benefit will result. Fair market value is based upon a variety of factors, including the individual's insurability and state of health, and could be significantly greater than CSV. The Canada Revenue Agency's (CRA) views on the valuation of life insurance policies are found in Information Circular IC89-3. Since a taxable shareholder benefit is not deductible by the corporation and does not qualify for dividend tax treatment to the individual shareholder, the transfer of an insurance policy to an individual shareholder is rarely recommended.

TRANSFERS FROM A CORPORATION TO A CORPORATE SHAREHOLDER

Where there is a corporate shareholder (Holdco), other planning opportunities present themselves. For example, if the policy is paid as a "dividend in kind" to Holdco, the dividend is generally tax-free. On the other hand, this still results in a disposition of the policy to the corporation and will cause tax liability where the CSV is greater than the ACB.

It is also possible for a shareholder benefit to arise where a policy is transferred to Holdco as a dividend. If the value of the policy is greater than the amount of the dividend, the excess could be taxable to Holdco as a shareholder benefit.

The possibility of tax-free dividends makes the transfer of a policy to a corporate shareholder more attractive than the equivalent transfer to an individual shareholder. Income tax and valuation concerns still remain, however.

The critical planning point is that policy ownership should be established properly from the beginning. Generally, where policies are owned by individuals or in holding companies, there is a reduced likelihood that a change in ownership will be necessary. Where insurance is owned in an operating company, there is a significant risk that ownership of the shares will change in the future and that this will necessitate a change in policy ownership. Thus, onerous tax consequences may result.

TRANSFERS FROM AN INDIVIDUAL SHAREHOLDER TO A CORPORATION

There is a curiosity in the tax rules relating to the transfer of insurance policies from an individual shareholder to a non-arm's length corporation. (This is essentially a corporation controlled by the individual and/or family members.)

The rules in question provide that, where a policy is transferred in these circumstances, the deemed proceeds will equal the policy's CSV even if the actual proceeds are a different amount. By way of example, assume that Harry owns a $1,000,000 Term to 100 policy on his own life that he acquired 20 years ago. The policy's CSV and ACB are both zero. Using actuarial principles and considering Harry's current insurability and state of health, an actuary has determined that the fair market value (FMV) of the policy is $600,000. On this basis, Harry sells his policy to his corporation, Harry Inc., for $600,000. The tax consequences of this transfer are as follows:

Actual proceeds $600,000
Deemed proceeds for tax purposes (CSV) 0
ACB of policy to Harry Inc. 0
Taxable income to Harry 0

 

As a result of this transaction, Harry receives $600,000 from Harry Inc., tax free, in exchange for the policy. Payment would be in the form of cash and/or a promissory note that could be paid down, without tax, at any time. This result assumes that the fair market transfer value of the policy can be substantiated if challenged by the CRA.

Although Harry Inc. paid FMV for the policy, it is deemed to have acquired the policy for proceeds equal to the CSV of zero. This means that on Harry's death, the full death benefit of $1 million will be credited to Harry Inc.'s capital dividend account and can be distributed as a tax-free dividend to the shareholders.

The CRA and the Department of Finance are aware of this anomaly in the Act and legislative change is always a possibility. In the meantime, this planning idea seems to be gaining in popularity.

 

GLENN STEPHENS, LLB, and KEVIN WARK, LLB, CLU, TEP

This article was published in the June 2008 issue of FORUM magazine. Posted with permission from the Financial Advisors Association of Canada (Advocis).

These resources are provided for reference only and do not necessarily represent the opinions of Guilfoyle Financial Inc. Please consult your own tax and legal advisors.