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CALU

CALU Report June 2003 - The CCRA Responds: Tax Policy Roundtable 2003

June 12, 2003

At the CALU Annual Meeting on May 6, 2003, Paul Lynch, Director of the Financial Industries Division of the Tax Rulings and Interpretations Directorate of the Canada Customs and Revenue Agency (CCRA), responded to various questions and technical issues concerning such issues as Critical Illness Insurance, interest deductibility, Health and Welfare Trusts, and charitable donations of life insurance policies. All statutory references are to the Income Tax Act (Canada) unless otherwise specified.

Table of Contents

Question 1: Critical Illness Insurance

In February 2002, we submitted a request for a technical interpretation on a variety of issues regarding critical illness insurance. Can the Agency provide an update or any guidance with respect to the issues raised in this request?

Agency's Response

Your request for a technical interpretation identified a number of issues respecting the application of the Act to holders of critical illness insurance. In response to your request, this Directorate has undertaken a comprehensive review of the issues raised. This review is not yet complete; however, we can provide you with an update.

You have advised that critical illness insurance may be issued as stand-alone insurance policies or as riders to life insurance policies. In both cases, where critical illness coverage is purchased, there may be available additional benefits, referred to as ROP or "return of premium" benefits, for an additional premium. ROP benefits, we understand, may be payable in the event of the policy-holder's death, the maturity of the policy, or periodically.

A key concern evidenced by your submission is how stand-alone critical illness policies will be characterized for purposes of the Act. In this respect, we think it may be relevant whether the policy includes ROP benefits and if so, the terms and conditions of the various benefits available under the policy.

Where a policy provides benefits only in the event of critical illness, we agree with your view that the policy should be viewed as a "sickness" policy, rather than a life insurance policy for purposes of the Act, notwithstanding that such policies are primarily issued by life insurers. In our view, the proceeds of disposition of such a policy would generally not be included in the policyholder's income under section 3 of the Act.

The appropriate treatment of policies providing benefits in addition to critical illness benefits is less clear. Some "ROP" benefits may well be life insurance. However, we have yet to satisfy ourselves that the primary coverage under such policies should dictate its treatment for purposes of section 148 of the Act in common law jurisdictions. We can confirm that this appears to be the case under civil law.

We understand that you have also raised these issues with the Department of Finance with a view to clarifying legislative intent with respect to critical illness policies. We expect to be working closely with the Department of Finance and with you in the coming months to clarify the remaining issues you have raised.

CALU Comment A joint CALU/CLHIA discussion paper will form the basis for consultations with both Finance and the CCRA to determine the appropriate tax treatment of both critical illness and long-term care insurance. As the consultation process will address many of the questions raised in CALU's interpretation request to the CCRA it is doubtful that we will receive a reply from CCRA with respect to that request until the consultation process is completed. CALU will continue to keep members informed.

Copyright CALU June 2003, The CALU Report

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Question 2: Update on CCRA's Review of Interest Deductibility Issues

Can the CCRA provide an update on the current status of the review and proposed new interpretation bulletin dealing with interest deductibility?

Agency's Response

As you know, on Oct. 1, 2002, we presented at the Canadian Tax Foundation an update on our preliminary review of our existing interpretative and administrative positions on interest deductibility. As part of this process, a consultation period followed during which we received comments regarding the proposed positions. In the near future, we anticipate that a new interpretation bulletin on interest deductibility will be issued setting out CCRA's official interpretations on interest deductibility issues. In addition, we will continue to consult with the Department of Finance.

On Feb. 18, 2003, as part of the presentation of the Federal budget, the Department of Finance announced that legislative amendments regarding interest will be considered.

CALU Comment: It is anticipated that the draft legislation will be released soon and CALU will review both the draft legislation and new interpretation bulletin, and determine if any submissions are required. CALU will continue to keep members informed with respect to any issues related to the field of advanced life underwriting.

Copyright CALU June 2003, The CALU Report

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Question 3: Health and Welfare Trusts

At the 2002 Canadian Tax Foundation meeting, M. Marc Vanasse, Director, Business and Partnerships Division, indicated that the CCRA was undertaking a review of IT-85R2, which gives the Agency's administrative position with respect to health and welfare trusts.

Can the Agency provide an update on the status of this review?

Agency's Response

We have completed our review of IT-85R2, and developed an internal draft of IT-85R3. This draft of the revised bulletin will be reviewed and commented on by other Branches in the CCRA as well as the Departments of Justice and Finance over the course of the next several weeks. Outside stakeholders will be consulted at a later date. It is anticipated that we will be able to publish the revised bulletin in June.

It should be noted that Income Tax Technical News no. 25 dated Oct. 30, 2002, contains the essential elements of what will be included in a future revision of the bulletin.

CALU Comment A copy of Income Tax Technical News no. 25 may be found at www.ccra-adrc.gc.ca/E/pub/tp/itnews-25/README.html. CALU has expressed interest in the consultations with respect to the revised Interpretation Bulletin. Income Tax Technical News no. 25 contains a number of questions and answers with respect to the CCRA's position regarding health and welfare trusts. The major area of concern surrounds the issue of funding health and welfare trusts, and the amount of the deductions that an employer can claim when money is contributed to a trust to fund the employees' benefits.

Copyright CALU June 2003, The CALU Report

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Question 4: Transfer of a Life Insurance Policy by a Corporation to a Shareholder or Employee

A corporation is the owner and beneficiary of an insurance policy on the life of a senior executive officer, who is also a shareholder. The policy was acquired to provide key person coverage to indemnify the corporation for a potential loss of profits or additional costs that may be incurred in the event of death of the insured. The individual retires and the corporation no longer needs the policy. The corporation transfers the policy to the individual for no consideration. Immediately before the transfer, the details of the policy are as follows:

The income tax implications of the transfer for the corporation and the individual appear to be as follows:

(i) Pursuant to subsection 148(7), the corporation is deemed to become entitled to receive proceeds of disposition equal to the cash surrender value (CSV) of the policy (i.e., $125,000)

(ii) Pursuant to subsection 148(1), the corporation must include $75,000 in computing its income - the excess of the deemed proceeds over the adjusted cost basis (ACB) of the policy. (i.e., $125,000 - $50,000).

(iii) Pursuant to either paragraph 6(1)(a) or subsection 15(1), the individual must include in income the fair market value of the policy (i.e., $125,000).

(iv) Assuming that the corporation transferred the policy to the individual because of the individual's position as a senior executive of the company and not because the individual was a shareholder, the corporation would be entitled to a deduction in computing its income for an amount equal to the fair market value of the policy (i.e., $125,000).

(v) Pursuant to subsection 148(7), the individual is deemed to acquire the policy at a cost equal to the CSV of the policy (i.e., $125,000).

(vi) Pursuant to the definition of "adjusted cost basis" in subsection 148(9), the ACB of the policy to the individual would include the cost of the policy as determined in (v) above and the amount included in computing the individual's income as determined in (iii) above. Accordingly, immediately after the transfer, the ACB of the policy to the individual would be $250,000 ($125,000 by virtue of the description of A and $125,000 by virtue of the description of C in the definition of "adjusted cost basis" in subsection 148(9)).

Does the Agency agree with the above description of the income tax implications for the corporation and the individual?

Agency's Response

Based on the facts set out in the question, and provided the "value" of the policy at the time of transfer as determined under the definition of "value" in subsection 148(9) is equal to the CSV of the policy, we agree with the income tax implications as set out in (i) to (v) above. However, with respect to the determination of the adjusted cost basis of the policy to the shareholder/employee as described in (vi) above, we disagree. In a transaction where,

a) subsection 148(7) applied to a transaction,

b) the fair market value (FMV) of the policy exceeded the CSV of the policy, and

c) the transferee was required to include an amount in income under subsection 15(1), in respect of the transfer,

then, we would allow the addition of the excess of FMV of the policy over the CSV policy in computing the ACB of the policy to the transferee. Where the FMV and cash surrender value of the policy are identical, there is no amount to be added to the ACB of the policy under C of the definition of ACB in subsection 148(9).

CALU Comment While a strictly technical reading of section 148 could result in a double counting, as contemplated in (vi) of the question, the more general provisions of subsection 248(28) would prohibit this.

Copyright CALU June 2003, The CALU Report

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Question 5: Sale of a Life Insurance Policy

If a corporation transfers a life insurance policy it holds on the life of an arm's length shareholder to that shareholder, in exchange for fair market value proceeds which exceed the CSV of the policy, would subsection 148(7) of the Act apply to deem the transfer to have taken place at CSV? Would your response be the same if the fair market value disposition was made to an arm's length employee, in respect of a life insurance policy held by the corporation on the life of that employee?

Agency's Response

The sale of a life insurance policy to an arm's length shareholder or to an arm's length employee, for proceeds equal to the fair market value of the policy, would not be viewed as a "distribution" from the corporation for the purposes of subsection 148(7) of the Act. However, it should be noted that whether or not a shareholder or an employee is dealing at arm's length with a corporation, such that it becomes relevant whether the transfer of the policy would be a "distribution" from the corporation, is a question of fact.

CALU Comment Subsection 148(7) will always apply when the transfer is to an employee or shareholder with whom the corporation does not deal at arms length. It is not necessary that such transfer be considered a distribution.

Copyright CALU June 2003, The CALU Report

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Question 6: Valuation of Corporate-owned Life Insurance Policy

Assume a corporation owns a life insurance policy on a shareholder's life. The life insurance policy has a cash surrender value (CSV) of $1 million. The corporation receives a policy loan for the full CSV and uses the funds to invest in marketable securities. The insured dies before the policy loan has been repaid.

In accordance with subsection 70(5.3) of the Act, in determining the value of the deceased's shares for the purposes of subsection 70(5), the value of the corporate-owned life insurance policy is its CSV, as defined in subsection 148(9). The definition of cash surrender value in subsection 148(9) requires that the CSV be determined without regard to any policy loans and, as a result, the value of the policy used to determine the value of the deceased's shares would be the full $1 million CSV. However, the value of the other assets of the corporation will reflect the $1 million of marketable securities acquired by the corporation with the proceeds of the policy loan.

Will the Agency confirm that, for the purpose of subsection 70(5), the policy loan will be treated as any other corporate liability and thus be taken into account in valuing the deceased's shares?

Agency's Response

Subsection 70(5.3) provides that the value of the insurance policy to be used in valuing the shares of the deceased is to be the cash surrender value of the policy, as defined in subsection 148(9). Accordingly, the amount of an outstanding policy loan immediately before the death of the life insured is not to be considered in valuing the policy as an asset of the corporation. In determining whether the policy loan is otherwise to be considered in valuing the deceased's shares for purposes of subsection 70(5), we would look to ordinary valuation principles.

CALU's Comment In determining the effect, if any, of the policy loan on the value of the deceased's shares presumably regard would be had to the terms of the policy loan to determine whether in fact it is a liability of the company.

Copyright CALU June 2003, The CALU Report

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Question 7: Reasonable Amount in Respect of Interest

Paragraph 20(1)(c) stipulates that interest on borrowed money may be deducted in computing a taxpayer's income from a business or property provided that specified conditions are met. However, paragraph 20(1)(c) also provides that the deduction is restricted to the amount of interest paid or payable "or a reasonable amount in respect thereof, whichever is the lesser."

In light of the potential variety of lending arrangements, what factors does the CCRA consider when determining whether the interest payable pursuant to a particular loan agreement exceeds "a reasonable amount in respect thereof?"

Agency's Response

The deduction for interest under paragraph 20(1)(c) is the lesser of the actual amount paid or payable and a reasonable amount. As stated in Shell, "where an interest rate is established in a market of lenders and borrowers acting at arm's length from each other, it is generally a reasonable rate." In considering whether an interest rate is reasonable or not, consideration will be given to comparable prevailing market rates for similar market risks with similar terms, and the existence of any issue premiums.

Copyright CALU June 2003, The CALU Report

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Question 8: Charitable Donations of Life Insurance Policies

There are many ways in which life insurance can be used as an effective instrument for the benefit of registered charities. However, in the past, arrangements have generally been restricted to the situations described in IT-244R3 where the ownership of a policy is absolutely assigned to a qualified donee and the donee is designated as the registered beneficiary of the policy. For a donation of an interest in a life insurance policy to qualify as a gift under common law, no right, privilege, benefit or advantage can accrue to the donor as a result of the gift.

A policyholder may wish to provide a portion of the benefits under a life insurance policy to a charity other than by means of an outright transfer of the policy to the charity. Such arrangements might include an irrevocable designation of the charity as a beneficiary for a portion of the death benefits payable under the policy. Other arrangements might involve "split-dollar" or other shared ownership arrangements where the policyholder and the charity enter into an agreement pursuant to which the rights and obligations under the policy are divided and shared between the parties.

Will the Agency provide general guidelines to assist policyholders and charities in determining whether an arrangement under which the life insurance benefits are shared between the charity and the donor will qualify as a charitable gift and how the value of the gift should be determined?

Agency's Response

In a situation where a policyholder makes a revocable or irrevocable designation of a qualified donee as the beneficiary of a life insurance policy for all or a portion of the death benefits payable under the policy, it is our view that the premiums paid by the policyholder on the policy will not qualify as a charitable gift since the policyholder has not donated an interest in the life insurance policy. However, subsection 118.1(5.2) will apply to deem the amount of the death benefit transferred to a qualified donee as a consequence of an individual's death to be a charitable gift for purposes of section 118.1 if all the requirements set out in subsection 118.1(5.1) are met. One such requirement is that immediately before the individual's death, the qualified donee was neither a policyholder under the policy nor an assignee of the individual's interest under the policy. Another requirement is that, immediately before the individual's death, the individual's consent would have been required to change the recipient of the death benefit. Accordingly, where there is an irrevocable designation of the qualified donee as the beneficiary of the policy, subsection 118.1(5.2) will not apply such that the death benefit received by the donee will not be deemed to be a charitable gift for section 118.1 purposes.

With regard to "split-dollar" or other shared ownership arrangements, it is possible that there may be arrangements that could result in a charitable gift for purposes of section 118.1 but such a determination can only be made on a case-by-case basis and we would need to review the particulars of a specific arrangement including all the relevant agreements and the life insurance policy. Since we have not had the opportunity to review specific shared ownership arrangements between donors and charities, it would be premature for us to attempt to provide general guidelines at this time or to comment on the impact, if any, of the draft gifting legislation released by the Department of Finance on Dec. 20, 2002, on such arrangements. Possibly, following the review of a number of shared ownership arrangements, we may be in a position to provide some general comments on whether a portion of the premiums paid on the policy would qualify as a charitable gift for tax purposes. However, such gifting arrangements would appear to fit within the spirit of the proposed legislation on split receipting.

CALU Comment The CCRA's observation that "where there is an irrevocable designation of the qualified donee as the beneficiary of the policy, subsection 118.1(5.2) will not apply such that the death benefit received by the donee will not be deemed to be a charitable gift for section 118.1 purposes" results in the worst possible outcome for the deceased - no charitable donation credit for the premiums paid during lifetime and no charitable donation credit in respect of the death benefit. CALU respectfully disagrees with this position. While an irrevocable beneficiary's permission is required to change the beneficiary designation, such a change also requires the consent of the policyholder. The policyholder's need to consent to the change is constant, whether the beneficiary designation is irrevocable or revocable. CALU will be making further representation to CCRA on this issue.

With respect to the CCRA's comments on the need to review a number of shared ownership arrangements before being able to comment on the portion of the premiums paid on the policy that would qualify as a charitable gift, it would seem this would be an ideal opportunity for CALU members to provide input to the CCRA on this issue. Members may wish to suggest to clients intending to enter into a split-dollar arrangement for charitable giving that they write the Rulings Directorate of the CCRA to obtain either a technical interpretation or an advance income tax ruling regarding the arrangement.

Copyright CALU June 2003, The CALU Report

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Question 9: Meaning of Control

Mr. A owns 80% of the shares of Corporation A. Mr. B owns all of the shares of Corporation B and 20% of the shares of Corporation A. Mr. A and Mr. B enter into an agreement that provides that, if either party wishes to sell his shares in either Corporation A or Corporation B, the other party is granted a right of first refusal to buy such shares.

We understand from a technical interpretation letter (Document No. 2002-0145225, dated Aug. 20, 2002) that the CCRA proposes to remove paragraph 13 from a forthcoming revision to IT-419R.

Based on paragraph 13 of IT-419R as it currently reads, the presence of a right of first refusal and/or "shotgun" provision in the shareholders' agreement would not be sufficient, in and of itself, for Mr. B to be deemed to control Corporation A as a result of the application of subparagraph 251(5)(b)(i).

Does the proposed removal of paragraph 13 from IT-419R mean that the CCRA has changed its position regarding the treatment of rights of first refusal and "shotgun" provisions in shareholders' agreements for the purposes of subsection 251(5)? If so, will Mr. B be considered to control Corporation A in the circumstances described above?

Agency's Response

The CCRA has not changed its administrative position. The CCRA is planning only to amend paragraph 13 of IT-419R, not to delete it. It is expected that the amended paragraph 13 will read substantially as follows:

Although the wording in paragraph 251(5)(b) may be broad enough to include almost any buy-sell agreement, this paragraph will not normally be applied solely because of a "right of first refusal" or a "shotgun arrangement" (i.e., an arrangement under which a shareholder offers to purchase the shares of another shareholder and the other shareholder must either accept the offer or purchase the shares owned by the offering party) contained in a shareholder agreement.

In light of the above, Mr. B's right of first refusal, in itself, would not ordinarily result in paragraph 251(5)(b) deeming Mr. B to control Corporation A in the circumstances described.

We note, however, that the administrative position set out in paragraph 13 of IT-419R is confined to rights contained in shareholder agreements, i.e., agreements between the shareholders of the corporation in question. As Mr. A is not a shareholder of Corporation B, the administrative position would not apply to the right of first refusal that he has with respect to Mr. B's shares of Corporation B.

Copyright CALU June 2003, The CALU Report

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