Collateral damage: The impact of new life insurance transfer rules

This year’s federal budget proposed measures that impact certain transfers of life insurance policies. But the broad nature of the proposed changes creates collateral damage in a number of areas.

The government has proposed changes to subsection 148(7) of the Income Tax Act (the Act), which governs the transfer of a life insurance policy:

by way of gift;
by distribution from a corporation (a sale for FMV to an arm’s length employee or shareholder is not considered a distribution from a corporation);
by operation of law only (for example, by right of survivorship on the death of a joint tenant); or
in any manner to any person with whom the policyholder was not dealing at arm’s length.

The government’s main target is the transfer of a life insurance policy to a corporation by a shareholder for FMV in excess of the “value” of the policy, defined in the Act as the cash surrender value (CSV), or nil where there is no CSV. Under pre-budget rules, the amount received on the transfer in excess of the CSV was tax-free; then, when the business owner died, the corporation would receive the death benefit tax-free and be able to distribute this amount to the shareholder (or his estate) essentially tax-free. Under the proposed rules, this would no longer be the case for post-budget transfers.

Trouble is, the broad nature of the relevant section of the Act means many other types of transfers may be impacted. This is also complicated by the proposal that, for transfers made before March 22, 2016 to which this section already applied, there will be a reduction to the capital dividend account (CDA) of a corporation for the excess of FMV consideration over the value of the policy when a death occurs on or after March 22, 2016.

The following are a few areas of collateral damage that seem to result from the proposals.

Prior transfer for FMV between related companies

Paying FMV may not have been done to engage in mischief. In fact, in some situations, it’s required to pay FMV so that the non-arm’s length party is not seen as receiving a benefit, the value of which would be included in income. Often, a policy is transferred from one company to another because it’s no longer needed in the one but may be needed in the other. Simple example: there’s going to be a sale of a business’ shares and the purchasers are not interested in owning a policy on the life of a former shareholder.

A transfer at FMV may be made to the shareholder, which could be a holding company. If the holding company does not pay FMV, it would have to report a shareholder benefit (this holds both under current rules and if the proposals go through). If a transfer of this kind were made pre-budget, subsection 148(7) would have already applied. If the holding company did pay FMV, there would now be an excess that would reduce the future CDA credit to the holding company, which would ultimately mean less of the death benefit will be permitted to be distributed tax-free. The portion that cannot be distributed as a tax-free capital dividend would have to be distributed as a taxable dividend.

If the prior transfer were made as a dividend in-kind (i.e., the policy was transferred in specie, the FMV of which is declared as a dividend), there would be no excess consideration and therefore no negative implications under the proposed rules.

If FMV consideration were provided on a prior transfer between sister corporations, then section 148(7) would have already applied and the proposals would impact the CDA to the transferee corporation. That is, there will be a permanent reduction to the CDA credit to the transferee corporation for the FMV minus the CSV received on the prior transfer. Again, that would ultimately mean less of the death benefit will be permitted to be distributed from the company tax-free under the post-budget regime.

Transfer at FMV followed by untimely death

For post-budget transfers, the proposals deem the proceeds of the disposition to the transferor to equal the value plus the FMV consideration in excess of the value. The proceeds, less the adjusted cost basis (ACB) of the policy, are reported on a T5 to the transferor as ordinary income.

The ACB to the transferee is reset at the deemed proceeds (e.g., if someone received $500,000, the ACB is now $500,000). This type of transfer may be made between corporations and FMV may be paid so that there are no shareholder or indirect benefits conferred in respect of the transfer.

What if a transfer is made of an insurance policy with no CSV and a zero ACB at FMV, and then the life insured dies the next day? The transferee corporation would get a CDA credit for the death benefit received, less the new ACB (reset at FMV). And the day before, the transferor would have reported income to the extent that the FMV proceeds exceeded the ACB of the policy. Over a normal life expectancy, the ACB to the transferee would be ground down by reductions, primarily from Net Cost of Pure Insurance. But in this situation, the ACB would not have had time to be reduced.

If this were a post-budget transfer into a corporation for FMV, the corporation would not have as big a CDA credit and would have to distribute tax-free death benefit proceeds as a taxable dividend to the shareholder (estate), with the deceased individual having just paid tax on the same amount the day before.

Here are some other possible consequences to watch out for.

Unwinding a corporate criss-cross buy-sell

Brother A and Brother B each have a holding company (Holdco A and Holdco B). Holdco A and Holdco B own 50% of an operating company, Opco. Holdco A owns insurance on Brother B and Holdco B owns insurance on Brother A. The underlying Opco is going to be sold to a third party. Holdco A and Holdco B want to swap their policies so that the insurance on Brother A is held by Holdco A and the insurance on Brother B is held by Holdco B.

Because Brother A and B are not at arm’s length, the proposed transfer rule applies. Let’s say both policies have the same FMV, but the FMV is greater than the CSVs of the respective policies. When Holdco A transfers Policy B, it starts with proceeds of disposition equal to the CSV of Policy B. However, if the FMV of Policy A (that Holdco A receives as consideration on the swap) is greater than the CSV of Policy B, Holdco A’s proceeds of disposition will get adjusted for the excess (difference between Policy A’s FMV and Policy B’s CSV). A similar result would happen to Holdco B. These adjustments would also be reflected in the new ACB of the respective policies.

Under the post-budget regime, then, both companies would be required to use the FMV of the acquired policy in excess of CSV of the transferred policy in calculating the tax that may be owing on the transfer. Pre-budget, this would have been calculated using the CSV of the policy being transferred out; but because the other policy being transferred in is the consideration, its FMV is relevant in calculating the tax owing on the policy being transferred out. FMV of a policy can and often does exceed its CSV.

Transfer into a corporation with multiple shareholders

On a post-budget transfer into a wholly owned company, a shareholder will not be required to receive FMV for a life insurance policy and could simply transfer a policy into a corporation for the value of the policy (CSV, or nil if there’s no CSV). There is a potential trap where the corporation into which a policy is being transferred has other shareholders. If the transferring shareholder does not take back FMV for the insurance policy, could there be a benefit conferred under other sections of the Act that could require an income inclusion to the shareholder(s)? Tax advice on this is a must.

Ideally, such transfers would be permitted rollover treatment under subsection 85(1) of the Act. In 2009, CALU made a submission to the Department of Finance requesting exactly that.

Bill C-15, containing many tax measures from the 2016 Budget, received second reading on May 10, 2016. The good news is the transfer provisions for life insurance were not in this first budget bill. CALU has put together a submission relating to these rules and some of the collateral damage they cause. We’ll just need to wait and see if the Department of Finance will budge on any of the proposals.