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At the CALU Annual Meeting on May 7, 2002, Brian Darling, Director of the Financial Industries Division of the Tax Rulings and Interpretations Directorate of the Canada Customs and Revenue Agency (CCRA), responded to questions concerning such technical issues as non-registered segregated funds, cost-plus plans, life annuity contracts and policy considerations in light of the Singleton and Ludco decisions. All statutory references are to the Income Tax Act (Canada) unless otherwise specified.
Table of Contents
Where a corporation sells a division of its business to another company, the new employer may agree to provide essentially the same benefits to the division's staff as did the original employer. If those benefits included benefits under a group segregated fund contract, the new employer could provide similar entitlements by entering into a new group contract with the same life insurer in respect of the same segregated fund with the members of the new group (i.e., the division's employees) having similar interests under the contract to those they held when they were members of the original group.
This type of situation was the subject of Rulings opinion 2000-0038745, dated April 20, 2001. In that opinion, Rulings expressed the view that the employees of the transferred division would be viewed as having disposed of their interest in the original group segregated fund contract as a result of changing group contracts.
Question
Wouldn't paragraph 107.4(2)(a) apply to this transaction to eliminate any adverse tax implications to the employees as a result of the disposition?
Agency's Response
Section 107.4 provides that a "qualifying disposition" is a disposition resulting from certain transfers of property to a trust. Where a disposition is a qualifying disposition, section 107.4 may provide a rollover in respect of the property transferred to the trust. As a segregated fund is deemed to be a trust for the purposes of the Act, it is our view that a disposition to a segregated fund may be structured so as to constitute a "qualifying disposition."
Rulings opinion 2000-0038745 discussed a hypothetical fact situation in which the certificateholders under a group segregated fund contract were "split off" from the group when the master policyholder under the group contract -- their employer -- sold a division of its company. Their new employer entered into a new group contract with the life insurer to provide interests in the same segregated fund to those employees.
In that fact situation, there was no transfer of property to a segregated fund. Therefore, section 107.4 did not apply.
The "qualifying disposition" rules in section 107.4 are relatively new (they were added to the Act in 2001 and apply to dispositions that occur after Dec. 23, 1998). The CCRA has had little opportunity to consider their application in specific factual circumstances. In particular, we have yet to consider the potential application of section 107.4 to transactions involving the division of a group that had shared an interest in a group segregated fund contract. We would expect that, in such circumstances, section 107.4 would most likely be relevant where the segregated fund itself is also divided as a consequence of the group's division.
It is difficult for us to speculate how those rules might apply to particular transactions. In particular, it is difficult to anticipate how the "notional trust" model the Act applies to segregated funds would accommodate the additional level of interests in a group policy without having an opportunity to consider the particular interests of the parties to the particular group contracts at issue in a qualifying disposition context.
We are prepared to consider the potential application of section 107.4 to particular rearrangements under a group segregated fund contract and would welcome your submissions in that respect.
Paragraph 6 of IT-430R3 reads, in part, as follows:
"A life insurance policy may be used to secure the indebtedness of a private corporation or a partnership with part or all of the proceeds arising upon the death of the person whose life was insured being paid directly to the creditor as beneficiary or as an assignee for security. In such cases, whether or not the premium cost is borne directly or indirectly by the debtor, the entitlement to the addition to the capital dividend account (or the entitlement of its partners to an addition to the adjusted cost base of each of their partnership interests) remains with that creditor (or its partners)."
Income Tax Technical News No. 10, dated July 11, 1997, stated that "[I]t was not intended that there be a change in the Department's position with regard to situations where a life insurance policy has been assigned as collateral for securing indebtedness, as opposed to an absolute assignment of the policy, and the debtor remains beneficiary under the policy. In such a case, as the proceeds of the insurance policy would be constructively received by the debtor/beneficiary, even though paid directly to the creditor in accordance with the assignment, the proceeds in excess of the adjusted cost basis of the policy would be included in the capital dividend account of the debtor. Paragraph 6 of IT-430R3 will be revised in this regard."
Questions
Agency's Response
CALU Comment: As it had been some time since the Technical News No. 10 had been released without a revision to IT-430R3, there was some concern as to whether the Revenue Agency was reconsidering its position with respect to the treatment of collaterally assigned life insurance policies. The fact that the Revenue Agency is reconsidering its position with respect to hypothecary claims in Quebec may be good news for Quebec corporations that have collaterally assigned life insurance policies. Currently, such an assignment is viewed by CCRA as not allowing a credit to the corporation's capital dividend account for the death benefit. CALU will continue to monitor this situation closely and report to members as soon as the CCRA releases its decision.
Over the past several years, CCRA has issued a number of interpretation letters issued dealing with private health services plans (PHSPs) and cost plus plans. Many of these have dealt with proprietorships where a cost plus plan was established for the proprietor and perhaps his/her spouse or other employees.
It appears that the main issue, which must be addressed in determining whether a cost plus plan is in fact a plan of insurance, is whether one person has undertaken to indemnify another person for loss. Even though a proprietor may enter into a contract with an administrator to pay medical and hospital expenses, that is not in itself sufficient to make the plan a private health services plan. However, consider a situation where the individual's spouse (or children) are actively involved in the business and receive insurance protection by way of a cost plus PHSP by virtue of their employment and not by virtue of being related to the proprietor.
Questions
Agency's Response
In our view, where the individual's spouse and children are covered under a cost plus plan that plan would be the same as if the proprietor would subscribe to a cost plus plan with an administrator on his own behalf. The same people are being covered under this arrangement; the proprietor, his or her spouse and children are all individuals who are members of the same household. The same invoices would be submitted to the administrator and the proprietor would be seeking a business deduction for the same amounts whether the individual, the spouse or their children submit the claims. Accordingly, in our view, this arrangement would not qualify as a PHSP.
As stated in technical interpretation letter #9904155, dated April 28, 1999, it continues to be our view that a plan which consists of a contract between a proprietor and an administrator, under which the administrator agrees to reimburse the proprietor, his or her spouse and members of his or her household for actual medical and hospital expenses and receives, as consideration, an amount equal to the amount reimbursed plus an administrative fee, does not qualify as a PHSP since it does not contain the necessary elements of insurance. In this situation, no person has undertaken to indemnify another person. Rather, the proprietor has assumed all of the risk for the personal hospital and medical bills. In our view, even though a proprietor enters into a contract with an administrator to pay medical and hospital expenses, this is not sufficient to conclude that the plan is a PHSP.
However, some concerns have been raised on the subject matter relating to cost plus plans and self-employed individuals. An internal review of our current position is under way and once this review is completed, a revision to IT-339R2 may follow.
CALU Comment: This response serves to clarify the Revenue Agency's position with respect to cost plus plans where both the proprietor/partner and other family members are insured. This was a grey area which now has some certainty.
There are situations where an annuity may be payable throughout the lifetime of an individual but that individual is not the recipient of the annuity payments. The individual may be an employee or a shareholder of a corporation and the corporation is the purchaser and owner of the annuity contract and also the recipient of the annuity payments. Such an annuity contract is not a prescribed annuity contract and as such is subject to the accrual rules pursuant to section 12.2.
Question
Is this annuity contract a "life annuity contract" pursuant to section 301 of the Income Tax Regulations?
Agency's Response
Such an annuity contract is not a "life annuity contract" pursuant to section 301 of the Income Tax Regulations since it does not meet the requirements of that provision.The definition of a "life annuity contract" within the meaning of section 301 of the Income Tax Regulations stipulates among other things that the annuity payments are to be made to an individual who is referred to as the "annuitant" and such annuity payments are to continue throughout the lifetime of the annuitant. In the above situation the annuity payments are made to a corporation and not to an individual as required by section 301 of the Regulations.
CALU Comment: Third-party life annuity contracts may be owned by charitable organizations or trusts, by an individual on the life of a spouse or former spouse or by corporations. The fact that a third-party life annuity contract does not qualify as a "life annuity contract," as defined in the Income Tax Regulations, means that a substantially higher amount of income must be reported for tax purposes than if the annuity were owned by and payable to the individual on whose life the annuity was issued.
CALU, in co-operation with CAIFA and the CLHIA, has written to the Department of Finance pointing out this anomalous situation and requesting an amendment to the Income Tax Act to rectify what is, in our view, an unintended situation. A copy of this letter has been posted to the public portion of the CALU website under "Submissions" as well as archived in the members-only site under "Issue Papers." We will keep members advised with respect to the progress of this important issue.
Some life insurance policies contractually provide for the substitution of one life insured for another. In providing such a contractual provision, life insurers are relying on both contract law and paragraph 148(10)(d) of the Act, which states that a policyholder is not deemed to have disposed of, or acquired an interest in, a life insurance policy as a result of only exercising any provision of the policy, other than the conversion of the policy into an annuity contract. Policies which contain substitute life provisions are used, as an example, in corporate-owned life insurance situations where the life insured is a key person. If the key-person leaves the company's employment and a new individual is hired, the new individual can be substituted as the measuring life under the contact without the disposition of the former contract and the issuance of a new policy.
During the past year, the CCRA has issued two interpretations which call into question substitute life policies, notwithstanding that the substitution of one measuring life for another is specifically allowed in the contract wording. The first interpretation was issued on Jan. 26, 2001 (document 2000-002117) and the second on Dec. 3, 2001 (document 2001-009612).
The first interpretation request dealt with a hypothetical universal life policy which provided for multiple-life coverage and for the addition of one or more life insureds after the policy was issued. In this instance, the policyholder wished to change the terms of the policy and add coverage on himself and his wife on a joint-and-last survivor basis and then drop the individual life coverages on each of them after the joint coverage was added.
The CCRA's response noted that it would not view the addition of insurance on individuals on a joint-last-to-die basis to be insurance on different lives because the joint coverage was in respect of the same lives that were already insured under the policy. The response went on to note that because the hypothetical situation being considered in the letter would not, in the CCRA's view result in a disposition of the contract, the existence of a contractual right to substitute life insureds, would not be relevant.
The Dec. 3, 2001, opinion dealt specifically with a substitution of the life insured. While it appears that the CCRA did not have the opportunity to review specific contract wording, it nevertheless offered some general comments. The response noted that the provisions of paragraph 148(10)(d) of the Act were intended to apply in cases where the policyholder has exercised certain contractual provisions. However, the reply went on to state it was the CCRA's view that this provision was not intended to allow the renegotiation of any of the terms of a policy or the addition of terms and conditions at a later date. From the reply, it appears that the CCRA would consider the substitution of the life insured as causing the renegotiation of the contract as it would necessitate other changes, such as a change in the premium structure of the contract. (It should be noted that in the situation referred to above, a change from insurance individual lives to a joint-and-last-survivor coverage would also have resulted in a premium change.) The reply stated that such changes may be sufficiently material as to cause the surrender of the original policy and the issuance of a new policy.
Both opinions use the term "sufficiently material" as the determining factor for whether a new contract would be created. This term is extremely subjective.
Question
In light of these interpretations, can the CCRA provide some guidance as to what changes in the terms and conditions of the policy would not result in a disposition of the contract?
Agency's Response
It is a question of fact whether a change to the terms and conditions of a life insurance policy is so fundamental as to result in the acquisition of a new policy. Such a determination can only be made after reviewing all the facts on a case by case basis. A determination would require the consideration of the law of contracts since an insurance policy is a legal contract. It would be necessary to determine whether the alteration of the agreement constitutes a variation of the existing agreement such that the original agreement survives, or whether the alteration is so fundamental that it results in the creation of a new contract between the parties and the extinguishment of the original agreement. There are several tax cases which have addressed the alteration of contracts between parties and whether the alterations have resulted in the creation of new contacts. These cases are Ronald J. Weibe et al, v. Her Majesty the Queen (87 DTC 5068) and John A. Amirault v. The Minister of National Revenue (90 DTC 1330), and the recent Federal Court of Appeal decision in General Electric Capital Equipment Finance Inc. v. the Queen (2002 DTC 6734).
The caution that we were attempting to provide in the two documents referred to in the question is that paragraph 148(10)(d) of the Act was never intended, nor do we believe provides, for the non-disposition of an insurance policy by simply recognizing that the policy may be materially changed. This would be the case where for example I take out a life insurance policy on the life of my son and simply make provision that at some future date I can substitute my life for my son's. In such a case consideration would also have to be given with regard to the determination of whether such a policy would qualify as exempt. If sufficient detail was provided in the policy such that no negotiation or renegotiation of the terms and conditions of the policy would be required in connection with the substitution, the exercise of the right of substitution provision may not result in a disposition.
We recognize our comments are subjective and have brought this matter to the attention of the Department of Finance for their consideration. In the meantime we are prepared to consider any particular arrangements you are proposing on a case by case basis.
An interest in a life insurance policy is disposed of by the policyholder to a person with whom the policyholder is not dealing at arm's length. Subsection 148(7) deems the policyholder to become entitled to receive "proceeds of the disposition" equal to the "value" of the interest in the policy. "Value" is defined in subsection 148(9) to generally mean the cash surrender value of the policy. The life insurance policy will have no cash surrender value at the time the policy is transferred. However, this policy will apparently have a cash surrender value in the future. The policyholder is a shareholder who controls a corporation and the shareholder wants to transfer the policy to the corporation for consideration equal to the fair market value of the policy.
Question
What are the "proceeds of the disposition" to the policyholder and the cost of the interest to the corporation pursuant to subsection 148(7)? Will there be a shareholder benefit pursuant to subsection 15(1)?
Agency's Response
Pursuant to subsection 148(7) the "proceeds of the disposition" to the policyholder are deemed to be equal to the "value" of the policy. Pursuant to the definition of "value" in subsection 148(9) since there is no cash surrender value at the time the policy is transferred the "value" would be nil and so would the "proceeds of the disposition". Consequently, the cost of the interest to the corporation would also be nil. Where the shareholder is receiving consideration equal to the fair market value of the policy there would not be a shareholder benefit pursuant to subsection 15(1).
The result of this transaction is that the shareholder is effectively receiving a distribution from the corporation on a tax-free basis. Notwithstanding that the corporation will have a reduced adjusted cost basis in the policy it is not clear that the above result is intended in terms of tax policy. We previously brought this situation to the attention of the Department of Finance and have been advised that it will be given consideration in the course of their review of policyholder taxation.
On Oct. 18, 2001, the Rulings Directorate of the CCRA issued a statement indicating that it was reviewing the Supreme Court of Canada's decisions in the Ludco and Singleton cases, both of which were decided in favour of the taxpayers. This review was to encompass an examination of all of the CCRA's interpretative and administrative positions regarding interest deductibility. The release noted that the CCRA would consult with the Departments of Justice and Finance during the course of the review. During the review process, the statement indicated that the CCRA would not modify any of its existing practices with respect to interest deductibility.
Question
Would the CCRA please comment on the status of the review with particular reference to:
Agency's Response
1. The significant interest deductibility issues under review of particular interest to this conference are:
2. The review process entails:
We are currently in the process of obtaining the tax policy input from Finance officials, and cannot at present accurately estimate the time needed to complete the review.
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