Budget closes two Life Insurance Tax Planning strategies

Photo.Robert Kepes
Robert Kepes

By Robert G. Kepes, Morris Kepes Winters

Special to the Financial Independence Hub

The March 22, 2016 federal budget closed two tax-planning strategies that involved the use of life insurance and private companies. Here is the first one:

Capital Dividend Account (CDA) Planning

The death benefit from an exempt life insurance policy is tax-free, and the same principle holds true if a private company is the beneficiary of the policy. The life insurance proceeds are added to the CDA of the private company when they can later be paid as a tax-free capital dividend to the shareholder. However, if the company is both the owner and beneficiary of the policy, then the amount that goes into the CDA is only the amount in excess of the adjusted cost base (ACB) of the policy.

For example, if the death benefit is $1 million and the ACB is $100,000, then only $900,000 is available for the CDA. Only $900,000 can be paid out tax-free, while the other $100,000 would be paid as a taxable dividend to the shareholder.

It follows that if the policy owner is not also the corporate beneficiary, then there is no reduction to the beneficiary’s CDA. A common planning strategy was to have ownership of the life policy in a parent holding company with the subsidiary company the beneficiary. This was done especially if the subsidiary was operating an active business and the owner did not want the policy to be an asset of the business that could be attacked by creditors.

Upon the death of the insured, the full death benefit of $1 million would go into the subsidiary’s CDA and be available to be paid out tax-free.

The federal government considers this to be inappropriate planning and an attempt to avoid paying tax on dividends (the $100,000 in my example).

Budget 2016 proposes to amend the CDA rules for private corporations so the limit of insurance benefit applies regardless of whether or not the corporation that receives the death benefit is a holder of the policy. To that end, the measure will also introduce information-reporting requirements that will apply where a corporation is not a policyholder, but is entitled to receive a death benefit.

This measure will apply to death benefits received as a result of a death that occurs on or after Budget Day.

Sales of Exempt Life Policies to Non-arm’s length Companies

The second plan struck down by the Budget involves the sale of a tax-exempt, life policy to a company that was non-arm’s length with the seller. In that event, the Income Tax Act considered the sale to occur at the cash surrender value (CSV) of the policy, and not at its fair market value, regardless of whether or not the company paid anything for the policy.

To implement the strategy, the owner would obtain a valuation of the policy from an actuary. Determining the value is a complex process depending on the owner’s age, health and mortality. For example, if a life policy has a death benefit of $1 million and a CSV of $100,000, then the value would be closer to $1 million than $100,000 if the person is older and in poor health.

The owner could sell the policy to his or her company for shares, cash or a promissory note of close to $1 million, but pay no tax on the sale because of the CSV rule in the Income Tax Act. In addition, if the company is also the beneficiary of the policy, then the death benefit would be received into the CDA, and available to be paid out as a tax-free dividend.

Budget 2016 proposes that, for transfers of policies after Budget Day, the seller will have to recognize a capital gain on the excess of the value of the policy over its CSV.

For transfers of policies that occurred before Budget Day, there is a measure that will reduce the amount that can be added to the company’s CDA. The reduction is generally equal to the value of the shares, cash or promissory note issued by the company as consideration for acquiring the policy.

Robert Kepes, BCL, LLB, TEP, is is a co-founder and partner with Morris Kepes Winters, a leading tax boutique law firm based in Toronto. He graduated from McGill University Law School (B.C.L./LL.B. ’84), and was called to the Bar of Ontario in 1986. Robert was Chair of the Tax Section of the Ontario Bar Association and was a Tax Instructor at the Law Society of Upper Canada for 10 years.



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