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At the CALU Annual Meeting on May 3, 2005, Mickey Sarazin, Acting Director of the Financial Industries Division of the Income Tax Rulings Directorate of the Canada Revenue Agency (CRA), responded to various questions and technical issues of current concern. For some questions, CALU has provided a note of clarification or comment concerning the official responses. CALU also thanks Denis Normand, Senior Chief of the Financial Institutions Section of the Business Income Tax Division of the Tax Policy Branch of the Department of Finance and William R. Holmes, Partner, Thorsteinssons, CALU´s Tax Advisor, for their participation in the Roundtable, and CALU's Director - Advanced Tax Policy, Ted Ballantyne, for his role in the development of the Roundtable and this publication. (Please note that all statutory references are to the Income Tax Act Canada unless otherwise specified.)
Table Of Contents
One of the conditions an annuity contract must meet to qualify as a ?prescribed annuity contract? is that its terms and conditions must require that ?all payments made out of the contract be equal annuity payments made at regular intervals but not less frequently than annually?? (clause 304(1)(c)(iv)(A) of the Income Tax Regulations). It is unclear whether this condition is satisfied if an annuity contract provides for equal periodic payments in U.S. dollars, or in some other currency other than the Canadian dollar. The condition would be satisfied if it is to be applied based on the amount of the payments expressed either in the currency of the contract or in the Canadian dollar equivalent using the conversion rate in effect at the time the contract is entered into. It would not be satisfied if it is interpreted to refer to the Canadian dollar equivalent of each payment at the time of payment, since the exchange rate can fluctuate (and almost certainly will).
The CRA appears to have accepted that a foreign currency annuity contract can be a prescribed annuity contract. In a letter dated Feb. 17, 2004 (document 2003-003982), the CRA held out the possibility that an annuity issued in the Netherlands could be a prescribed annuity contract. The annuity contract in question was clearly not a Canadian dollar contract.
a) Does the CRA agree that the above-noted equal payments condition is to be applied to the payments under an annuity contract expressed in the currency of the contract?
b) If the CRA agrees with this, is the capital element of each payment to be determined under subsection 300(1) of the Income Tax Regulations using Canadian dollar amounts computed based on the exchange rate at the time the annuity contract is issued?
a) In our view, the ??equal annuity payments made at regular intervals but not less frequently than annually?? condition set out in clause 304(c)(iv)(A) of the Income Tax Regulations is to be applied to the payments under the annuity contract expressed in the currency of the contract.
b) We have not previously had the opportunity to address this particular issue and as such are unable at this time to provide a clear answer. We are continuing to analyze the issue with the goal of providing a technical interpretation to CALU in the near future.
Part (a) of this question relates solely to a condition that must be met for an annuity contract to qualify as a prescribed annuity contract. In computing the annuitant´s income for tax purposes, the payments would have to be translated into Canadian dollars, with the result that the amount included in income could fluctuate from year to year due to exchange rate fluctuations.
A corporation creates a special class of non-voting shares that entitle the holder to dividends as declared by the directors. The directors may only declare dividends on the shares out of the proceeds received by the corporation as the beneficiary of a life insurance policy on the death of its sole shareholder, and only to the extent that the proceeds are added to the corporation´s capital dividend account. The corporation is the owner of the policy and pays the premiums under the policy. The special shares are redeemable at the option of the corporation for $1 per share.
The corporation issues one special share to the shareholder´s adult child for $1.
Does the Agency agree that subsection 15(1) is not applicable with respect to the acquisition of the special share by the shareholder´s child?
Provided that the issue price of $1 reflects the fair market value of the special share at the time of issuance, it is our view that subsection 15(1) will not apply to include a benefit in the child´s income as a consequence of the child acquiring the special share.
CALU Comment: In asking this question, it was hoped that the CRA would agree that the fair market value of the special share is $1. Unfortunately, they have followed their usual practice of not taking a position on valuation matters.
In response to Question 4 at the 1992 CALU Annual Conference, the CRA expressed the view that where a corporation that owns a life insurance policy winds up into another corporation in circumstances such that subsection 88(1) applies, rollover treatment applies to the distribution of the policy. The subsidiary corporation is deemed to have disposed of the policy for proceeds of the disposition equal to the adjusted cost basis of the policy to the corporation, and the parent corporation is deemed to be a continuation of the subsidiary for the purposes of determining the adjusted cost basis of the policy to the parent.
The CRA´s analysis in support of this position does not make reference to subsection 148(7). That provision applies, inter alia, where a corporation disposes of an interest in a life insurance policy by way of distribution to any person, or in any manner whatever to a non-arm´s length person. The disposition of a life insurance policy in the circumstances described above is a type of disposition referred to in subsection 148(7). Where the subsection applies, it deems the interest to be disposed of for proceeds of the disposition equal to the cash surrender value of the policy, and to be acquired at a cost equal to this amount.
Another point not explicitly considered in the CRA´s analysis is the interaction between paragraph 87(2)(j.4) (which applies by virtue of paragraph 88(1)(e.2)) and paragraph 88(1)(c). Paragraph 87(2)(j.4) deems the parent corporation to be the same corporation as, and a continuation of, the subsidiary corporation for purposes of determining the adjusted cost basis of the distributed policy. Paragraph 88(1)(c) deems the cost of the policy to the parent to equal the subsidiary´s proceeds of disposition.
If a Canadian corporation is wound up in circumstances such that subsection 88(2) applies, the property distributed on the winding-up is deemed by subsection 69(5) to have been disposed of for fair market value proceeds. This deemed disposition is for the purpose of computing the corporation´s income. The shareholder to whom a particular property is distributed is deemed to have acquired the property at a cost equal to its fair market value. It is unclear whether these rules apply with respect to the distribution of an interest in a life insurance policy, or whether subsection 148(7) applies.
a) Does the CRA agree that subsection 148(7) is not applicable on the distribution of a life insurance policy in connection with the winding-up of a corporation in circumstances such that subsection 88(1) is applicable?
b) In the CRA´s view, what effect, if any, does paragraph 88(1)(c) have on the determination of the adjusted cost basis of a life insurance policy that has been distributed to a parent corporation?
c) In the case of the winding-up of a corporation to which subsection 88(2) applies, which of subsection 69(5) and subsection 148(7) is applicable to the distribution of an interest in a life insurance policy?
a) Yes. The specific rules for windings-up in subsection 88(1) will apply and will override the rules in subsection 148(7) with respect to non-arm´s length dispositions of life insurance policies.
b) Pursuant to paragraphs 88(1)(e.2) and 87(2)(j.4), the adjusted cost basis (?acb?) of the life insurance policy to the subsidiary corporation will be the acb of the life insurance policy to the parent corporation. Accordingly paragraph 88(1)(c) has no effect on the calculation of the acb of the policy to the parent.
c) The general rule is that where two provisions in the same statute conflict, the more specific provision should take precedence. In this case there is no clear indication as to which provision is the more specific. While we are inclined to the view that subsection 69(5) would apply where the disposition of the policy occurs pursuant to a subsection 88(2) wind-up, we would want to review the facts of the particular case to ensure that this provides for a reasonable result.
The question of whether a rollover rule displaces subsection 148(7) was previously considered in connection with subsection 107(2). The CRA took the position that subsection 107(2) applied instead of subsection 148(7) when a personal trust distributes a life insurance policy to a beneficiary in satisfaction of the beneficiary´s capital interest. See CRA document 9641405 as well as the response to Question 9 at the 1999 CALU Annual Meeting, which was released as CRA document 9908430.
A corporation borrows money from a restricted financial institution (as defined in subsection 248(1)), and uses the money to acquire a life annuity contract on the life of its sole shareholder. Payments under the annuity contract commence immediately. The amount of interest payable on the loan for each year exceeds the amount included in the corporation´s income for the year under subsection 12.2(1) in respect of the annuity contract. Consequently, except in the taxation year in which the annuity contract is acquired, only a portion of the interest is deductible under paragraph 20(1)(c).
As a condition for the loan, the lender requires that the corporation purchase a term life insurance policy on the life of its shareholder and that this policy be assigned to the lender as collateral for the loan.
Can the corporation claim deductions under paragraph 20(1)(e.2) in respect of the life insurance premiums, subject to the limits in that paragraph? More specifically, is the condition in clause 20(1)(e.2)(i)(B) satisfied for a particular year if only part of the interest on the loan for the year is deductible?
The premiums from a life insurance policy used to guarantee a loan may be deductible under paragraph 20(1)(e.2) of the Act if the interest payable on the loan is deductible in computing the income of the borrower in the year or would be deductible in the year but for subsections 18(2) and (3.1) and sections 21 and 28 of the Act.
Subparagraph 20(1)(c)(iv) of the Act permits a deduction for interest on money borrowed and used to acquire an interest in an annuity contract in respect of which section 12.2 of the Act applies (or would apply if the contract had an anniversary day in the year at a time when the taxpayer held the interest) except that, where the annuity payments have begun under the contract in a preceding taxation year, the amount of interest paid or payable in the year shall not be deducted to the extent that it exceeds the amount included under section 12.2 of the Act in computing the taxpayer´s income for the year in respect of the taxpayer´s interest in the contract.
As a result, a portion of the interest on money borrowed and used to acquire an interest in an annuity contract may be not deductible in the calculation of income of a taxpayer. However, in our view, the condition stated in clause 20(1)(e.2)(i)(B) of the Act is met for the taxation year if part or all of the interest is deductible in the year by virtue of subparagraph 20(1)(c)(iv) of the Act. If no interest is deductible in a taxation year, the condition is not met for that taxation year.
CALU Comment: The CRA provided a favourable response to a similar question in CRA document 2004-0077031E5.
Scenario 1: A taxpayer borrows money to use in its business. Interest on this loan is fully deductible under paragraph 20(1)(c). To pay all or part of this interest, the taxpayer borrows money under a second loan.
Scenario 2: A taxpayer borrows money which she uses to acquire shares of a corporation. Interest on this loan is fully deductible under paragraph 20(1)(c). To pay all or part of the interest, the taxpayer borrows money under a second loan.
Is the interest on the second loan in both scenarios deductible under paragraph 20(1)(c)?
Scenarios 1 and 2:As indicated in Income Tax Rulings document #2004-007034, we are of the view that interest paid or payable in the year (following the method regularly used by a taxpayer in calculating income) on the second loan is deductible in calculating income of a taxpayer from a business or property pursuant to paragraph 20(1)(c) of the Income Tax Act if the interest on the first loan is deductible pursuant to that provision in calculating the income of the taxpayer from that business or property.
In connection with a universal life insurance product, an insurer offers a side account facility. This account is used to hold amounts which the policyholder pays to the insurer, to the extent that the amounts would result in the policy ceasing to be an exempt policy if they were credited as premiums under the policy. Also, if any amounts must be withdrawn under the policy in order to maintain its exempt status, the withdrawn amounts are credited to the side account. Amounts are automatically transferred from the side account and credited to the policy to the extent that this is possible without causing the policy to lose its exempt status. The policyholder is permitted to withdraw all or any part of the balance in the side account at any time. The balance in the side account at any particular time will be the total of all deposits and transfers to the side account, plus all positive return amounts credited to the side account, minus all withdrawals and transfers from the side account, minus all negative return amounts credited to the side account prior to that time. The amount available for withdrawal will also be subject to the insurer's administrative rules and fees.
The terms relating to the side account are set out in an appendix to the life insurance policy. The appendix states that the side account has been established to accompany the policy, but is separate from and external to the policy. It also provides that amounts placed in the side account are not premiums under the policy until withdrawn from the side account and credited to the policy.
The insurer offers several investment options for the side account. In selecting a particular investment option, the policyholder is choosing a method for determining the investment return to be credited to the portion of the side account to which the particular option applies. For example, the policyholder may select the daily interest option for the whole side account, in which case interest would be credited to the side account at a rate that varies daily. The investment options include the S&P/TSX Composite Total Return Index and certain other indexes. When the policyholder selects an index as the investment option, each day´s percentage change in the index is used to determine the return (which may be negative) to be credited to the side account.
Assume that in year 1 an individual deposits $1,000 into a side account to a UL policy, and selects the S&P/TSX Composite Total Return Index as the investment option. The index increases during year 1 and, at the end of the year, the account balance is $1,050.
It appears that in this example the insurer has no obligation under the Income Tax Regulations to prepare T5 slips in respect of the side account, since the insurer does not make a payment of a type referred to in subsection 201(1) of the Regulations, the side account is not a debt obligation, and no amount is included in the individual´s income pursuant to the provisions referred to in subsection 201(5) of the Regulations.
a) Does the CRA agree that income and losses that result from the S&P/TSX Total Return Composite Index are to be reported for tax purposes as gains and losses on income account and only in the year in which amounts are withdrawn from the side account?
b) Does the CRA agree that the insurer has no reporting obligation in the above example?
a) Generally, amounts credited to an investor are included in income in the year in which they are credited to the investor rather than in the year they are withdrawn from the investor´s account. With regard to this particular arrangement, several issues need to be considered to determine the tax consequences to the investor. First, it would be necessary to determine whether the side account is a debt obligation at law. Then it must be determined whether the amounts credited to the side account constitute interest, an amount paid in lieu of or in satisfaction of interest, or some other type of income. The reporting obligations of the insurer in respect of the side account will also flow from the determination of the nature of the return earned in connection with the side account.
b) The determination of the legal nature of the indexed side account and the characterization of the return thereon for income tax purposes may vary depending upon the terms of each particular agreement between the insurer and the holder of the indexed side account. We would be willing to consider this issue further in the context of specific situations where all of the relevant documentation has been provided to us.
CALU Comment: The question that CALU originally asked contained a specific example of increases/decreases in the side fund and asked the CRA whether they agreed with the tax consequences that were described in the example. The CRA felt it would be inappropriate to provide a specific response to a hypothetical scenario in the absence of specific policy provisions to review. If the tax treatment of indexed side accounts is of concern to a CALU member or client, then it is suggested that the member´s or client´s professional advisor write the Income Tax Rulings Directorate of the CRA for an opinion, providing the appropriate documentation. Alternatively, if desired, such enquiries can be co-ordinated through Ted Ballantyne, CALU´s Director, Advanced Tax Policy. However, it should be noted that without detailed policy information, it is doubtful that the CRA will provide more than a general response.
Will subsection 148(8) apply where a child is the contingent owner of a policy within the meaning of subsection 199(1) of the Insurance Act (Ontario), the policy is a last-to-die policy, the child and one of child´s parents are the only lives insured under the policy and the parent dies?
If the child receives the interest of the parent policyholder in the last-to-die policy for reason only that the child is the contingent owner of the policy within the meaning of 199(1) of the Insurance Act (Ontario) and the parent has died, it is our view that the child is the only life insured under the policy at the time that the parent´s interest in the policy is transferred to the child. Provided that the child acquired this interest without consideration, it is our view that subsection 148(8) would apply to the transfer of the policy from the parent to the child, such that the deceased parent would be deemed to have disposed of the policy, immediately before the transfer, for proceeds of disposition equal to the adjusted cost basis of the policy to the parent, and the child will be deemed to have acquired an interest in the policy at a cost equal to those proceeds.
CALU Comment: While this question dealt specifically with the contingent ownership provision in the
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