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CALU

CALU Report - Dispositions of Life Insurance Policies

By Dereka Thibault, CA, CFP, TEP; and Joel Cuperfain, BA, LL.B., LL.M., TEP, CLU

October 13, 2008

In this issue of CALU Report, CALU member Joel Cuperfain and Dereka Thibault, AVP of Tax and Estate Planning in Manulife Financial's Calgary office, consider some of the more common transactions involving transfers of life insurance policies, how to value a life insurance policy and the tax consequences associated with the transfer. Valuation issues surrounding life insurance policies are of growing importance, be it for estate planning purposes, charitable giving or corporate reorganizations.

CALU thanks the authors for taking their time to share their expertise on this complex topic.

Regards Ted Ballantyne, BBA, LLM, CMA, TEP, Director, Advanced Tax Policy, Conference for Advanced Life Underwriting

Table Of Contents

Introduction

There are a number of circumstances where it may be necessary to determine the value of a life insurance policy for tax purposes. For example, the owner of a policy may choose to transfer ownership to another person. Alternatively, in the case of a corporate owned policy, the policy may have an impact on the value of the shares of the corporation. This article will consider some of the more common transactions involving transfers of life insurance policies, how to value a life insurance policy and the tax consequences associated with the transfer.

A transfer of ownership of an interest in a life insurance policy is considered a disposition for tax purposes. When there is a disposition of an interest in a life insurance policy, the Income Tax Act (Canada)[1] requires the policyholder to include in income any taxable policy gain. A taxable policy gain is equal to the proceeds (or deemed proceeds) of the disposition[2] less the adjusted cost basis (ACB)[3] of the policy or interest in the policy being disposed. Since life insurance is not capital property, a taxable policy gain is fully included in income. In the case of a private corporation, the gain is treated as passive investment income. A deduction is not available if the proceeds of disposition are less than the ACB. That is, a policy loss is not recognized under the Act.

There are a number of different transactions which can constitute a disposition of an interest in a life insurance policy for tax purposes. The total or partial surrender of the policy (i.e., withdrawing funds from the policy), policy loans and transfers of ownership are included as a disposition. The collateral assignment of a policy as security for a loan is specifically excluded from the definition of disposition of an interest in a life insurance policy as are payments arising on the death of the life insured under the policy or a payment under the policy as a disability or accidental death benefit.[4]

Assuming we have a taxable disposition of a life insurance policy, how do we determine the amount of any policy gain? In other words, how do we value an interest in a life insurance policy? The Act provides very limited assistance in this regard. In some cases, there will be a specific provision of the Act which will determine how an interest in a life insurance policy is to be valued. In the absence of such a provision, reference must be made to general provisions of the Act, case law (both tax and non-tax), the Canada Revenue Agency's (CRA) administrative guidelines, policy statements, technical interpretations, round table responses and accepted valuation principles.

Copyright the Conference for Advanced Life Underwriting, October 2008

Rollovers

The Act allows for a limited number of rollovers in respect of certain transfers of ownership of a life insurance policy.

(i) Spousal Rollover

There is a spousal rollover, both inter vivos[5] and at death[6] but there is no rollover for transfers to a spousal trust (inter vivos or at death). Further, there are no rollovers available for transfers to any type of trust including alter ego trusts and joint partner trusts.

(ii) Intergenerational Rollover

The Act allows for a tax-free rollover to a child in limited circumstances where:

1. the policy is transferred for no consideration to the policyholder's child; and
2. the life insured is a child of the policyholder or a child of the transferee.[7]

For purposes of this rollover, the definition of "child" is very broad and includes children, grandchildren, great-grandchildren and persons who at any time before attaining the age of 19 were wholly dependent on and in the custody of the taxpayer.[8]

CRA technical interpretation letter #2001-0098185 dated Oct. 17, 2001, confirms that a rollover is not allowed if the policy is transferred to the owner's child and the owner is the life insured under the policy.

CRA's traditional position is that the transfer of a policy must be to a child directly. Transfers cannot occur to a trust even where a child may be a beneficiary under the trust and would otherwise qualify under the provisions for the rollover as a "child".[9] Further, a transfer by way of will does not qualify for the rollover as the policy would first be transferred from the deceased to the deceased's estate and then from the estate to the deceased's child.[10] However, at question 7 of the 2008 CALU CRA Roundtable, the CRA indicated that transfers to a Guardian of the Property of a minor under Ontario's Substitute Decisions Act[11] would qualify for the rollover.

(iii) Transfer from a Trust

There are two conflicting provisions which could apply where a personal trust transfers a life insurance policy to a capital beneficiary of the trust. Subsection 107(2) provides for a roll out of property of a personal trust in satisfaction of a capital beneficiary's interest in the trust, at the property's "cost amount".[12] On the other hand, subsection 148(7) deems the disposition of a life insurance policy by way of gift or non-arm's-length transfer to occur at the policy's "value". Value is defined in 148(9) as the policy's cash surrender value or nil if there is no cash surrender value attributable to the interest in the policy being disposed of. The CRA has been asked how it would resolve this potential conflict and has confirmed that in such a circumstance, the rollover available under subsection 107(2) would prevail.[13]

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Situations Where the Act Specifies Value

In the case of a simple surrender of the policy, the proceeds of the disposition are easily determined. The proceeds of the disposition would be equal to the amount of any cash payment from the insurer to the policyholder. However, many dispositions involving life insurance policies do not involve a cash payment. In such circumstances, the Act may or may not provide guidance in determining the value of the policy.

Subsection 148(7) deems the proceeds of the disposition to be the cash surrender value where the transfer is the result of a gift or the transfer is made to a non-arm's-length person.[14] In addition, subsection 148(7) will also apply where the disposition is the result of a "distribution" from a corporation.

CRA has indicated that subsection 148(7) will not apply where a corporation "sells" a life insurance policy to an arm's-length employee or shareholder, as this would not constitute a distribution from the corporation.[15]

In some circumstances there may be two specific provisions that could define the proceeds of disposition. For example, where a subsidiary is wound up and subsection 88(1) applies, the subsidiary is deemed to dispose of all "property" (not just capital property) for its cost amount to the subsidiary, and the parent corporation is deemed to acquire the property for this same amount. Subsection 248(1) indicates that cost amount of a property (not otherwise described) is the cost as determined for the purpose of computing the taxpayer's income. This would mean that the cost amount of the policy to the subsidiary is its adjusted cost basis.

However, it appears that 148(7) would also apply to this transaction as a "distribution" is being made to a non-arm's-length party, and as a result the deemed proceeds would be the cash surrender value of the policy.

The CRA expressed its views in resolving this conflict at the 2005 CALU Annual General Meeting. The CRA indicated that the specific provisions of subsection 88(1) would override subsection 148(7) on the wind up of a wholly owned subsidiary such that a rollover would apply and the transfer would take place at the policy's adjusted cost basis.

Copyright the Conference for Advanced Life Underwriting, October 2008

Transfers Between Corporations and Shareholders

There may be circumstances where a shareholder may have an existing life insurance policy and would like to transfer this to the corporation. If the shareholder is not dealing at arm's length with the corporation, subsection 148(7) provides that the deemed proceeds of disposition will be equal to the cash surrender value of the policy, regardless of the actual proceeds.

There is nothing that precludes the company from paying fair market value for the policy, if this amount is greater than the cash surrender value. In this situation, the shareholder would still report deemed proceeds of cash surrender value.[16]

In some situations, it may be desirable to move a life insurance policy from one corporation to another corporation controlled by the shareholder. This might be done, for example, as part of a creditor protection reorganization that would also see other assets transferred out of an operating business.

Once again, in a non-arm's-length situation, it is clear that the deemed proceeds continue to be cash surrender value.

In addition to this, if the transferee corporation is a shareholder of the transferor, it will have a shareholder benefit to the extent the fair market value of the policy is greater than the amount paid for the policy. To avoid this result, the transfer of the policy could be in the form of a tax-free dividend in kind[17] paid to the corporate shareholder. The amount of the dividend would be equal to the fair market value of the policy, and should preclude any shareholder benefit inclusion.

Care will need to be taken to ensure that the dividend will not result in other issues, for example the anti-avoidance rule at subsection 55(2) which would recharacterize the otherwise tax free intercorporate dividend as a capital gain.

In the non-arm's-length situation, if the transferee company is not a shareholder, the deemed proceeds to the transferor corporation continue to be the cash surrender value of the policy. This would apply for example, where the transfer is between sister corporations (corporations with the same or related shareholders). Since the sister corporation is not a shareholder, there is no concern with a shareholder benefit issue. However, it is possible that an indirect benefit could be assessed to the shareholder directing the transfer by virtue of subsection 56(2) or section 246.

Where an insurance policy is owned by a corporation, circumstances will often arise that require it to be transferred to a shareholder. For example, many shareholders agreements provide for the transfer of a corporate owned life insurance policy to a retiring shareholder, when the insurance is no longer required for funding a buy-sell obligation. Once again, where the recipient shareholder is not dealing at arm's length with the corporation, the deemed proceeds of the policy to the corporation will be equal to its cash surrender value.

However, as with any other asset transferred to a shareholder or employee, the shareholder/employee will have a deemed benefit to the extent the fair market value of the policy is greater than the amount actually paid.[18]

If the shareholder is also an employee of the company, if possible, steps should be taken to ensure that any taxable benefit is structured as an employee benefit in order for the corporation to be able to claim a deduction of this amount.

Subsection 70(5.3) provides that for the purposes of determining share value on the deemed disposition on death of a shareholder, or on becoming a non-resident, the value of any life insurance policy on the life of the individual or non-arm's-length individual is deemed to be the cash surrender value.

This provision is extremely important for purposes of determining valuation of shares on the death of a shareholder, particularly where death is imminent. However, corporate owned life insurance policies on all other individuals who are arm's length to the deceased or the individual leaving Canada, are valued at fair market value and not cash surrender value, for purposes of determining share value.

When determining whether or not the shares of a corporation are qualified small business corporation shares, or family farm corporation shares for purposes of claiming the enhanced capital gains exemption the value of the underlying assets at the point in time must be determined. According to the CRA, if 10% or more of the corporation's assets are "passive", the shares will not qualify for the capital gains exemption.

The CRA normally considers all corporate owned life insurance policies to be passive assets and not assets used in an active business. Key person insurance used to recruit, hire or train new employees might be considered an active business asset. However, all corporate owned buy-sell insurance would be treated as passive assets.

The question then becomes how to value a life insurance policy for purposes of determining the percentage of non-active business assets owned by a corporation.

The value of a life insurance policy insuring the life of the individual whose estate is claiming the capital gains exemption on the deceased's shares will be the cash surrender value of the policy, as long as the proceeds are used within 24 months after death to redeem or acquire the shares of the deceased. In all other cases, corporate-owned life insurance policies will be valued at fair market value.[19]

The definition of small business corporation is also important for purposes of the income imputation rule at section 74.4. For purposes of the rule, the deeming provisions at section 110.6 do not apply and as a result all insurance policies would be valued at fair market value.

Copyright the Conference for Advanced Life Underwriting, October 2008

Valuation of a Life Insurance Policy

The Act does not specify how a life insurance policy is to be valued where the value is something other than the policy´s cash surrender value. The CRA has expressed its administrative views in Interpretation Bulletins (see IT-140R3 and IT-416R3) and Information Circular 89-3. Information Circular IC 89-3 lists the following criteria as being relevant in determining the value of a life insurance policy:

For example, if the individual whose life is insured would now be rated because of ill health or is uninsurable, the fair market value of the policy would exceed the policy´s cash surrender value. Based on these criteria, it would be possible for a life insurance policy to have a fair market value well in excess of the cash surrender value. In other words, the cash surrender value would represent the floor, not the ceiling, for valuation purposes.

There is no income tax case law that addresses the issue of valuation of a life insurance policy. However, there is a 1999 Saskatchewan family law decision which provides some guidance. In Paterson v. Remedios[20] the husband was the owner of a term life insurance policy. When he discovered he was terminally ill, he changed the beneficiary of the policy from his soon-to-be ex-wife to his girlfriend. The relevant date for valuing the life insurance was after the husband had been diagnosed with his illness. The husband, in fact, died within a year.

The court found that given the health status of the husband, the policy on his life did have value which the court fixed at approximately 50% of the death benefit. The judge pointed to the fact that although term insurance policies generally have no cash surrender value, persons who are terminally ill may in fact receive some or all of the proceeds of the term insurance prior to their death, and therefore term insurance policies may have value.

This case opens the door for other courts to place a value on term insurance policies.

With the possible introduction of legislation permitting so-called "viatical settlements", (i.e., buying and selling insurance policies on the lives of third parties) we may soon see an actual "market" for life insurance policies. This new market could help establish fair market value parameters.

Actuaries and certified business valuators may be retained to determine the value of a life insurance policy. The factors that they will typically take into consideration would include the factors listed in Information Circular 89-3. Valuators will, for example, look at the cash value of the policy. They will also consider the discounted value of the future death benefit (after reflecting any ongoing premium obligations). Of course, differing discount rates will lead to significant variations in value. Another methodology might be to base the value of the policy on replacement cost. Other factors that could have an impact on the value of the life insurance policy would be any special features or riders associated with the policy. These special features may be especially significant where the product feature is no longer available in the market. For example, the policy might be a UL policy with a relatively high guaranteed minimum interest rate in relation to newer generation policies. Alternatively, the particular policy may no longer be available in the marketplace. These factors could also have an impact on value.

Assuming the CRA accepts these valuation methods, they will probably use similar methods to value policies in circumstances when the taxpayer would rather have the policy value limited to cash surrender value. This might be the case where a policy is transferred from a corporation to a shareholder. Therefore, insurance advisors and their clients need to consider planning ahead. This is particularly important in shareholder buy-sell situations, where the shareholder may retire and want to take the policy out of the corporation

If there are holding companies in place already, perhaps the Holdco should own the individual life insurance policy on its shareholder. Where the funding is required in Opco on the death of a shareholder, Holdco would simply name Opco as a beneficiary. As indicated before, when the time comes for the individual to retire, his holding company would simply change the beneficiary designation, and this would not result in a disposition of the policy.

Dividends could be paid to the holding companies so that funds are available to pay the premiums. One of the problems with this approach is that the premium cost is not shared according to shareholdings, and this may be an issue depending on the age and health of the various shareholders. Another approach is to have separate classes of common shares issued to the holding companies that would allow separate dividends to accommodate differing premium obligations.

Some advisors suggest that Opco can simply pay the premium even if the holding company owns the policy, since it is the beneficiary of the policy. Is the payment that Opco is making a "rental" payment to Holdco for the "use" of the beneficiary designation, and if so, is it taxable to Holdco? Would Holdco be able expense the life insurance premium (which is normally non-deductible)?

And of course, in considering ownership issues, if it is intended that part or all of the premium will be deducted as a collateral insurance deduction, the borrower of funds must also be the owner.[21]

Transfers of Inforce Policies to Charities

The CRA has recently indicated that when a charity receives a donation of a life insurance policy, it can issue a charitable donation receipt equal to the fair market value of the policy.[22] The CRA indicated in recent bulletins to charities, that it will be the responsibility of the charity to ensure a proper valuation of the policy is completed. The donor will still be deemed to receive proceeds of disposition equal to the cash surrender value of the policy pursuant to subsection 148(7). This position was most recently confirmed by the CRA at the 2008 CALU Tax Roundtable.

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Conclusion

Valuation of insurance policies is expected to become a growing issue. More and more policyholders are undertaking transfers of policies, be it for general estate planning purposes, charitable purposes or as part of corporate reorganizations. Tax consequences of such transfers may well be substantial. Prudent policyholders will consider the long-term insurance needs in determining policy ownership at the time of first acquiring the policy.

Copyright the Conference for Advanced Life Underwriting, October 2008

About the Authors

Dereka Thibault is AVP Tax and Estate Planning in Manulife Financials' Calgary office and may be reached by e-mail at Dereka_Thibault@manulife.com or by phone at (403) 355-4931. Joel Cuperfain is a CALU member and is AVP Tax and Estate Planning in Manulife Financials' Toronto office. He may be reached by e-mail at Joel_Cuperfain@manulife.com or by phone at (416) 369-2998.

Endnotes

[1] Income Tax Act, R.S.C. 1985, c. 1 (5th Supplement), as amended, hereinafter referred to as the "Act". Unless otherwise stated, statutory references in this Article are to the Act.
[2] As defined by subsection 148(9) of the Act.

[3] Also defined at subsection 148(9).

[4] See definition of "disposition" in relation to an interest in a life insurance policy at subsection 148(9).

[5] Subsection 148(8.1). This rollover applies to common law partners and also to inter vivos transfers to a former spouse or common law partner in settlement of rights arising from their relationship.

[6] Subsection 148(8.2).

[7] Subsection 148(8).

[8] Subsection 148(9) defines the term "child" to include the definition found in subsection 70(10) of the Act.

[9] See Technical Interpretation Letter #9826715 dated Jan. 19, 1999.

[10] See technical interpretation letter #9433865 dated Feb. 15, 1995. However, a transfer by way of successor owner would qualify for the rollover. See technical interpretation letter #9618075 dated Sept. 3, 1996.

[11] Substitute Decision Act, R.S.O. 1992 S.O. 1992, c. 30.

[12] In the circumstances, this would be the policy's ACB.

[13] See CRA document #9908430.

[14] Subsection 148(7) refers to "value" of the policy which is further defined in Subsection 148(9).

[15] See CRA document #2003-004285.

[16] This was confirmed by the CRA at the 2002 CALU Annual General Meeting Roundtable. See CRA Document #2002-0127455.

[17] Subsection 112(1) of the Act.

[18] By virtue of paragraph 6(1)(a) or subsection 15(1) of the Act.

[19] See paragraph 110.6(15)(a).

[20] (1999) 29 E.T.R (2d) 279 (Q.B.)

[21] See paragraph 20(1)(e.2) and paragraph 1 of Interpretation Bulletin IT-309R2 Ð Premiums on Life Insurance Policies used as Collateral.

[22] Question 1 at the 2007 APFF CRA Roundtable.