Controlling shareholders’ life policies get new treatment

A way of structuring life insurance policies to avoid creditors or reduce corporate taxes following the death of controlling shareholders has been reviewed by the Canada Revenue Agency. As a result, life insurance premiums paid by a subsidiary company to cover the life of the parent company’s controlling shareholder are getting new tax treatment. The new policy will apply in situations in which the beneficiary of the life insurance policy is the parent firm.

In a break with previous guidance, the CRA has announced that it will treat the premiums in the cases outlined above as a shareholder benefit. As such, the premiums will be taxable in the hands of the parent company.

This shift in interpretation was announced by the CRA at a conference held by the Association de planification fiscale et financière in October 2009 and again at the annual Canadian Tax Foundation conference in November 2009.

Before this change, the CRA had indicated in a 1998 technical interpretation that Subsection 15(1) of the Income Tax Act did not apply in these situations. That section says that, generally, when a corporation confers a benefit on a shareholder, it will be considered as income.

Although the CRA did not provide a clear reason for the change, Mark Symes, director of the CRA’s income tax rulings directorate, suggested at the CTF conference that the revised stance was more in line with recent rulings from the courts: “If there is an impoverishment [cost to] the corporation and an enrichment [benefit to] the shareholder, then normally there is a benefit conferred, and 15(1) would apply, subject to exceptions. We think that in this situation, there is a benefit conferred.”

The CRA says it will begin applying the revised policy for any new life policies with these features beginning Jan. 1, 2010, but will delay applying the policy to existing structures until Jan. 1, 2011.

The new CRA policy will have no impact on other, more traditional, ownership situations, such as those in which a corporation is both owner and beneficiary of a policy or in which the parent company is the owner of a policy and the subsidiary is the beneficiary.

At least one tax and estate planning expert believes the CRA’s new interpretation conforms more closely to the general principles of Canada’s income tax laws. Says Joel Cuperfain, an estate planning specialist with RBC Dominion Securities Inc. in Toronto: “If the beneficiary were an individual, rather than a corporation, the CRA would clearly say there was a shareholder benefit. I couldn’t figure out why the CRA would take a different position just because the [beneficiary] shareholder happens to be a corporation rather than an individual. I don’t know why the CRA held its old position. It didn’t make sense; this [new CRA position] makes sense, on the law.”

For a variety of tax and estate planning purposes, individuals may set up a parent or holding company between themselves and a subsidiary or operating company. If there is a need for insurance — say, to fund tax liabilities upon the death of the controlling shareholder — that insurance could be held by the operating company, with the holding company named as beneficiary. One possible advantage of this structure is that the death benefit would be out of the reach of any creditors.

Another advantage is that the value of the death benefit that flows to the holding company will be credited to the holding company’s capital dividend account without the CDA credit being reduced by the adjusted cost base of the policy. If the owner of the policy and the beneficiary of the policy were the same company, the CDA would be reduced by the adjusted cost base of the policy.

(The CDA is a notional account that tracks certain tax-free amounts that a corporation receives. Down the line, if the corporation so chooses, it can pay out dividends from the CDA to Canadian, resident shareholders as tax-free capital dividends, up to the amount in the CDA.)

In making the change, the CRA is more closely adhering to its position — first articulated back in the 1998 technical interpretation bulletin — that if, in its opinion, the insurance has been structured to “unduly increase the CDA” and not for any other bona fide reason, then the general anti-avoidance rule could be applied. The CDA credit then would be reduced by the insurance policy’s adjusted cost base.

For those who already have their insurance structured so that the policy is owned by the operating company and the beneficiary is the parent company, a relatively easy fix exists: change the beneficiary designation to the operating company. However, as the owner of the policy is also the beneficiary, the CDA will now be reduced by the policy’s adjusted cost base.

Kevin Wark, senior vice president of business development with Toronto-based PPI Financial Group Inc., says he generally has not recommended clients get into structures in which the insurance policy is held by the subsidiary or operating company because that can create unfavourable tax consequences if the shareholder, down the line, wants to sell the operating company but retain the insurance policy.

“The transfer of a policy to a shareholder needs to take place at fair market value or a shareholder benefit can be assessed,” Wark says. “We typically recommend that the insurance be owned outside of the operating company, so that if the opco is sold, we don’t have to be worried about transferring the policies and creating a disposition and potential shareholder benefit.”

Cuperfain says the CRA’s change of approach is an indication that it should be the tax laws, and not the CRA’s interpretation of them, that should guide financial advisors.