Liquidating life insurance

Life insurance is often an important tool for funding a liquidity event, such as the death of a business owner, as the proceeds can be used to immediately pay off creditors and provide often much-needed cash flow in a time of business uncertainty.

Business owners who operate their business through a corporation often choose to hold such life insurance inside the corporation for a variety of reasons, one of which is that from a tax point of view, an absolute savings can be realized if life insurance premiums are paid for by the corporation. That’s because, generally speaking, life-insurance premiums are not tax-deductible and thus it becomes cheaper to pay these non-deductible premiums with cheaper, after-tax corporate dollars.

In such cases, the corporation typically owns the policy and the death benefit can generally be paid out of the corporation to its shareholders, either mostly, or in many cases, entirely tax-free, as a special dividend, known as a capital dividend.

Most advisors emphasize to the business owner that the corporation should be the beneficiary of the life insurance policy so that the death benefit flows directly from the life insurance company into the corporation’s capital dividend account (CDA).

But what happens if a third party, such as a bank offering creditors’ life insurance (one of the few types of insurance banks are permitted to offer) insists on being named as the beneficiary of the policy? Upon the death of the key shareholder, will the death benefit, paid from the insurance company directly to the third party creditor, still constitute an amount received by the corporation through its CDA and therefore be subsequently used to pay out a tax-free capital dividend?

That was exactly the subject of recent dispute between a corporation, Innovative Installation Inc. (“Innovative”), and the Canada Revenue Agency, which landed in Tax Court late last year (Innovative Installation Inc. v. the Queen, 2009 TCC 580.)

In 1999, Innovative borrowed $220,000 from RBC and obtained key person insurance from Sun Life Financial on the life of its founder Rod Peacock. Peacock died in 2002 and Sun Life paid the $196,000 death benefit directly to RBC, which applied $175,500 to pay off the balance on the loan and directed the balance of $21,422 to Innovative’s bank account.

In June 2004, Innovative declared a tax-free capital dividend in the amount of $160,000 and included the amount of the death benefit on the Sun Life insurance policy in calculating the balance of its CDA.

The CRA disagreed and found the dividend in excess of Innovative’s actual CDA balance and applied the special penalty tax of 75% under Part III of the Income Tax Act for an excessive capital dividend election, resulting in a tax bill of $120,000.

Needless to say, Innovative appealed this penalty tax to the Tax Court.

Under the Income Tax Act, for the death benefit from a life insurance policy to be included in a corporation’s CDA, “the corporation must have received proceeds of a life insurance policy after May 23, 1985 in consequence of the death of any person.”

The CRA cited its own Interpretation Bulletin IT-66R6, Paragraph 6, subparagraph (d), which states the CDA includes “the net proceeds of a life insurance policy received after May 23, 1985 by the corporation as beneficiary under the policy.” The CRA maintained that since RBC was the beneficiary of the policy, it “received” the death benefit and therefore no amount can be included in the calculation of Innovative’s CDA balance.

The Judge found the CRA’s position “defies common sense and natural justice.” He observed the Tax Act’s definition of the CDA does indeed require Innovative to receive the insurance proceeds but concluded that Canadian tax jurisprudence has held that the word “receive” in the Act refers to the party that receives the benefit of the insurance proceeds. Innovative clearly derived the benefit of the insurance payout since it had its loan paid off and its net worth increased.

As a result, the Judge concluded that Innovative received the proceeds within the Act’s definition of “capital dividend account” and thus was entitled to add the proceeds of the death benefit to its CDA and pay a $160,000 tax-free capital dividend without being subjected to the punitive Part III tax.