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CRA Opinions: UL, CDA and IRA

September 30, 2004

The following is a summary of recent opinions from the Canada Revenue Agency concerning the disposition of an interest in a Universal Life policy, the Capital Dividend Account and the tax treatment of an IRA on death of a Canadian resident, as prepared by Ted Ballantyne, BBA, CMA, TEP, Director, Advanced Tax Policy, CALU.

Table of Contents

Opinion # 1: Disposition of an interest in a universal life policy

The CRA was asked whether a disposition of an interest in a universal life insurance policy, insuring more than one life, occurred under the following five scenarios:

1) An amount becomes payable when the first insured dies and the amount is paid to stipulated beneficiaries.

2, 3 and 4) The policyholder(s) have discretion whether or not a death benefit will be paid, in whole or in part, when a life insured under the policy dies.

5) A policy with last-to-die coverage is amended to add first-to-die coverage.

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Background notes

The actual questions were not provided in the CRA's response, which was issued on June 25, 2004 (document # 2003-0042861E5), nor is there any further information on the scenarios. The CRA assumed that the lives insured under each scenario are also the named beneficiaries under the policy and that one or more of these individuals are the policyholders.

As a prelude to making comments on the individual scenarios, the CRA stated that the factual circumstances at the time of a payment, particularly the terms and conditions of the life insurance policy, would indicate whether or not the payment was made as a consequence of the death of any person whose life was insured under the policy. Such payments are excluded from the definition of 'disposition' in subsection 148(9) of the Income Tax Act ('the Act') by virtue of paragraph (j) of the definition.

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First scenario

In the CRA's view, the payment made under the first arrangement is unlikely to result in a disposition of any interest in the policy as it would likely be made as a consequence of the death of a life that is insured under the policy.

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Scenarios 2, 3 & 4

The second, third and fourth scenarios all involve policyholder discretion as to whether a benefit will be paid in the event of the death of a life insured when there is a surviving life insured under the policy. The CRA's response indicates that it is not clear to them that such payments would necessarily be viewed as made as a consequence of the death of the life insured. After noting the flexibility that is often built in to universal life policies to access the funding, the CRA commented that a policyholder entitled to receive payments on request prior to the death of a life insured would not be viewed as receiving such payments as a consequence of the death of a life insured under the policy merely because the payments are requested after the death of a life insured.

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Fifth scenario

The CRA noted that the fifth scenario posed a different issue than the first four: the issue here was whether the change to the policy would be so fundamental as to result in a disposition of the policyholder(s)'s interest in the policy. A material change to a life insurance contract that results in a new contract at law generally results in a surrender of the policyholder's interest in the original contract and the acquisition of an interest in the new contract. The definition of 'disposition' specifically includes a surrender of an interest in a policy. The CRA also observed that subsection 148(10) of the Act must be considered. That subsection provides that a policyholder is deemed not to have disposed of an interest in a life insurance policy as a result only of the exercise of any provision of the policy, with the exception of the conversion of the policy to an annuity contract.

Assuming that subsection 148(10) does not apply, the CRA stated it was unclear whether a disposition would result from the change proposed in the fifth scenario, as it is a question of fact and law whether particular changes made to a life insurance policy are so fundamental as to result in a disposition of the policyholder(s)'s interest in the policy. The CRA has no general guidelines for making this determination.

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CALU comments re: above opinion

At the May 2000 CALU Tax Policy Roundtable, CALU asked the CRA a question about the appropriate tax treatment of a payment at the first death under a joint last-to-die life insurance policy. (See CALU Tax Policy Roundtable Report, 2000, Question 2.) At that time, the CRA indicated that its position was as follows:

it appears that the insurer is not at risk with respect to the amount payable on the death of the first person since the actual death benefit is paid upon the death of the second person and effectively there is no mortality risk assumed by the insurer in respect of any benefit that may be paid on the death of the first of the two lives named under the policy. It appears reasonable to conclude that the only life insured under the policy is that of the person that is last to die.

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CALU follow-up

In June 2000, CALU wrote the CRA and asked them to reconsider their opinion on the basis that the relevant condition is that the payment be made 'in consequence of death' and that under the wording of the Act there is no requirement that the insurer be 'at risk' with respect to all or any portion of the amount payable.

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CRA response to CALU

On Sept. 11, 2000, the CRA responded (document # 2000-003388) and conceded that given the broad language used in paragraph (j) of the definition of disposition in subsection 148(9) of the Act and the lack of expressed legislative intent we agree that, subject to the terms of a specific policy, the relevant words could be interpreted to include the payment made as a consequence of the first to die under a joint last to die policy with the result that the payment of the benefit would not constitute the "disposition" of an interest in the policy or a "policy loan" as defined in subsection 148(9) of the Act.

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Summary of CALU comments

The CRA's response to the current question does not contradict the opinion that CALU obtained in 2000. Its statement regarding the first scenario is consistent with that opinion. The policies in scenarios 2, 3 and 4 differ from the type of policy on which that opinion was based, in that those policies do not specifically provide for a payment at the first death, but permit the policyholders to determine whether such a payment is to be made.

In considering the fifth scenario, the CRA made the assumption that subsection 148(10) of the Act would not be applicable in respect of the specific arrangement presented to them. If the policy provisions did provide the policyholder with the right to have the change made, then there is an argument that the change would fall within subsection 148(10) and that there would be no disposition.

More generally, where multiple life policies are involved, the Act and Income Tax Regulations provide little by way of guidance. The 1998 submission by the Canadian Life and Health Insurance Association (CLHIA) to the Department of Finance regarding proposed modifications to the exempt test did raise the issue of multiple life policies. Little has happened since that submission was made.

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Opinion # 2: Capital Dividend Account

On June 11, 2004, through a technical interpretation, the CRA addressed the issue. If a private corporation deducted life insurance premiums in calculating its income, can the net proceeds of the life insurance policy be added to its capital dividend account? (document # 2004-0068141E5). The CRA responded that the fact that premiums have been deducted would not make any difference to the capital dividend account addition.

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Entitlement to the CDA addition

The CRA's response went on to reiterate their position set out in paragraph 6 of IT-430R3 regarding entitlement to the capital dividend account addition. If a life insurance policy is used to secure the indebtedness of a private corporation where all or a portion of the proceeds arising upon the death of the life insured are paid directly to the creditor as beneficiary or as assignee, then the entitlement to the addition to the capital dividend account remains with the creditor and not with the private corporation. On the other hand, when a life insurance policy has been assigned as collateral for securing indebtedness (as opposed to an absolute assignment of the policy) or is the subject of a hypothecary claim by the creditor, and the debtor remains the beneficiary or policyholder, then the proceeds in excess of the adjusted cost basis of the policy would be included in the debtor's capital dividend account.

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CALU comment re: above

For further background regarding the CRA's position, readers can refer to Question 2 of the 2002 CALU Tax Policy Roundtable report archived in the Advanced Tax Policy section of www.calu.ca.

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Opinion # 3: Tax treatment of IRA on death of Canadian resident

The CRA was asked to consider a situation which involved the tax consequences upon the death of a U.S. citizen who had immigrated to Canada two years prior to the date of the interpretation request and who held an IRA immediately before death. In making the interpretation request to the CRA, the enquirer had reviewed CRA document #9800545, dated Aug. 10, 1998, and had expressed the opinion that the position expressed in that document would seem to be inconsistent with tax policy, which takes deliberate measures to ensure that pre-residence gains are not subject [to] Canadian taxation'. The enquirer referred to certain provisions in the taxation rules applying to immigrants and emigrants as being good examples of this. In addition, the enquirer's position was that as the value of the IRA would not be included in computing the deceased person's U.S. 1040 income tax return in the year of death and may not attract U.S. estate tax if the value of decedent's estate is sufficiently low, exposing the IRA to Canadian taxation only serves to make the result more onerous'.

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CRA assumptions

In their response of April 16, 2004 (document # 2003-0046111E5), the CRA assumed that the IRA is a foreign retirement arrangement (FRA) rather than a pension plan or other entity recognized under the Act. FRAs are defined to be certain types of IRAs.

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CRA position

The CRA noted that, as stated in their previous opinion (referred to above), where the owner of the IRA dies before the plan's maturity and the property in the plan was not previously used to acquire an irrevocable annuity, it is their view that the interest in the IRA constitutes a right or thing' within the meaning of subsection 70(2) of the Act. Subsection 70(2) includes in the income of a deceased taxpayer the value of rights or things that meet the following condition: had the taxpayer continued to live and realized or disposed of the rights or things, the amount of the rights or things would have been included in the taxpayer's income. In applying subsection 70(2) with respect to an IRA, any amount that would not have been required to be included in the income of the owner if the owner had received a payment under the IRA before death is to be excluded. Pursuant to clause 56(1)(a)(i)(C.1) of the Act, amounts received under an IRA that would not have been taxable if the owner were a resident of the U.S. are not included in income.

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CALU comment re: above

Subject to the foregoing comments, the position previously stated in 1998 continues to represent the CRA's position, since that position was based on the assumption that the full amount of the IRA, that would be considered to be an FRA, would have been taxable in Canada had it been realized or disposed of before death. That position was premised on an interest in an IRA being considered to be a right or thing for the purposes of the Act.

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