Advocis Vancouver Conference Tax Efficient Uses of Life Insurance

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1 Advocis Vancouver Conference Tax Efficient Uses of Life Insurance Glenn Stephens, LLB October 2012

2 Topics for Discussion 1. Introduction to the Taxation of Life Insurance 2. Use of Life Insurance in Family Business Succession 3. Corporate Beneficiary Designations 4. Transfers of Policies between Corporations and Shareholders 5. Transfers of Policies to Charity

3 1. Introduction to the Taxation of Life Insurance

4 Some Basics Some basics: Premiums generally not deductible Proceeds tax free Tax free accumulation in exempt policies (exempt test changing per 2012 budget) Proceeds less policy s adjusted cost basis ( ACB ) credited to capital dividend account ( CDA ) and may be distributed tax free to shareholders

5 Premiums Affordability of premiums: Premiums not deductible therefore should be paid by taxpayer with lowest tax rate For example: Corporation in 16% tax bracket needs to earn $1,191 in order to have $1,000 remaining for payment of premiums Individual in 45% tax bracket must earn $1,819 to have $1,000 remaining

6 Transfer of Life Insurance Policies Transfer of life insurance policy is disposition for tax purposes Where cash surrender value ( CSV )>ACB excess is taxable to transferor (fully taxable, not capital gain) Where CSV<ACB no loss may be taken Limited rollovers for certain transfers between family members and out of trusts

7 Adjusted Cost Basis Generally equals aggregate of premiums less net cost of pure insurance ( NCPI ) NCPI = yearly mortality cost prescribed in Income Tax Regulations ACB can decline to nil (but not become negative)

8 Impact of ACB The lower the ACB, the greater the likelihood of a taxable gain when policy transferred during lifetime The lower the ACB, the higher the CDA credit when proceeds are paid to a private corporation

9 Purposes of Corporate-Owned Life Insurance Buy-sell funding Key person coverage Collateral for bank loans Payment of estate liabilities via payment from CDA (e.g. funding tax costs and/or estate equalization)

10 Advantages of Holding Companies Ownership of life insurance by holding company usually preferred over ownership by operating company: Creditor protection Avoid future policy transfers CDA advantage Premiums often funded via tax free dividends received from operating company with low tax rate

11 2. Use of Life Insurance in Family Business Succession

12 Family Business Succession Strategies 1. Estate freezes including use of family trusts 2. Funding tax liability 3. Fully funding buyout of parents shares

13 Estate Freezes As asset value grows, so does future income tax liability Estate freezes allow individual to freeze current values and pass future growth to others Typical example: parent freezes shares of family business corporation and passes future growth to children or family trust

14 Preferred Shares Usually have voting control Can also provide source of retirement income and capital: Annual dividends and/or Gradual redemption strategy (wasting freeze)

15 Crystallizing the Capital Gains Exemption May crystallize $750,000 capital gains exemption in course of estate freeze Generally done by filing s.85 election form which sets the disposition price at the desired level

16 Role of Trusts Trust holds shares on behalf of family Distribute shares later to active/able children Multiple access to capital gains exemption if shares sold Parents can be beneficiaries allows freeze to be unwound if needed Remember 21 year rule

17 Funding Tax Liability Assume parents have $3 million of preferred shares with no ACB Capital gains exemption unavailable If shares gifted to children on death tax is: $3,000,000 x 50% x 43.7% = $655,000

18 Insure to Pay Tax Formula to calculate amount of tax/insurance: Tax otherwise payable/1+ (MTR-DTR) TOP ($3 mil. x 50% x 43.7% = $655,000) MTR = Marginal Tax Rate DTR = Dividend Tax Rate 655,000/1 + ( ) = 595,000 (round up to $600,000)

19 Insure to Pay Tax Process: Calculate no. of shares that can be redeemed using double the amount of insurance proceeds ($600,000 x 2 = $1,200,000 out of $3 million) Estate gives shares (other than those being redeemed) to children Remaining shares are redeemed for $600,000 cash and $600,000 note

20 Insure to Pay Tax Capital gains tax on gifted shares: $1,800,000 x 50% x 43.7% = $393,300 Deemed dividend on redeemed shares: $1,200,000 x 50% (taxable portion) x 33.7% = $202,200 Total tax = $595,500

21 Summary Tax on gift = $655,000 Tax on partial redemption/gift = $595,500 Savings = 9.1%

22 3. Corporate Beneficiary Designations

23 Corporate Beneficiary Designations Which corporation should be owner and beneficiary of insurance policy? Need not be (and sometimes should not be) the same corporation

24 Opco Owner/Holdco Beneficiary CDA = Death Benefit (Holdco ACB = 0) (GAAR?) Shareholder benefit to Holdco (per change in CRA administrative practice announced in 2009) Structure not recommended Beneficiary Holdco Owner and Payor Opco

25 Holdco Owner/Opco Beneficiary CDA = total proceeds but CRA suggests GAAR may apply if main reason to avoid tax Other potential reasons for structure include creditor protection and avoidance of future transfers CDA benefits often a secondary consideration Owner and Payor Holdco Beneficiary Opco

26 Example 1 Simple to control & implement Policies subject to creditors of AB Co. Allows for redemption and/or cross purchase Issue regarding possible ownership change in future Insured Mr. A Mr. B Owner Payor A Co. B Co. Beneficiary AB Co.

27 Example 2 Requires AB Co. to declare a dividend to A Co. and B Co. Equal dividends for each class Creditors of AB Co. may restrict payment Policy not subject to AB Co. creditors A&B support own cost of insurance Insured Mr. A Mr. B Owner Payor A Co. B Co. Beneficiary AB Co.

28 Example 2 (continued) No issue re change of ownership of policies A&B manage own policies independent of one another Allows for cross purchase or redemption Maximize CDA subject to GAAR Insured Mr. A Mr. B Owner Payor A Co. B Co. Beneficiary AB Co.

29 Example 2 (continued) Per CRA potential taxable benefit to AB Co. Questionable whether CRA position correct is clear that there is no taxable benefit in arm s length situations Insured Mr. A Mr. B Owner Payor A Co. B Co. Beneficiary AB Co.

30 Example 3 Same as previous except AB Co. pays premiums for its share of insurance coverage Per CRA potential income inclusion because of reimbursement difficult to see how CRA position supportable Insured Mr. A Mr. B Owner A Co. B Co. Payor Irrevocable Beneficiary AB Co.

31 4. Transfers of Policies between Corporations and Shareholders

32 General Principles Non-arm s length transfers: deemed proceeds = policy s value*, which also becomes transferee s ACB Arm s length transfers: proceeds and transferee s ACB = actual proceeds * Value for these purposes generally equates to cash surrender value (CSV)

33 General Principles (continued) Where CSV>ACB = excess is taxable to transferor (fully taxable, not capital gain) Where CSV<ACB no loss may be taken No section 85 rollover for life insurance policies

34 Valuation Value for certain purposes equates to policy CSV (e.g. for calculating deemed proceeds of disposition/acb on non-arm s length transfers) For other purposes policy s FMV (not CSV) is relevant (e.g. for determining any taxable benefit on transfer of policy to shareholder or employee, and in calculating amount of charitable donation)

35 Fair Market Value Information Circular 89-3 CRA views Relevant factors include: Policy face amount and CSV State of health/life expectancy of insured Perceived imminence of death Replacement value of policy Actuarial analysis recommended

36 Valuation Example $1 million term to 100 policy issued on healthy 50 year old male (NS) $10,500 annual premium Estimated future values assuming continued good health: Age 60 $150,000 Age 70 $350,000 Age 80 $550,000

37 Transfer of Insurance Policies between Corporations and Shareholders Will review 4 different non-arm s length transactions: 1. Transfer from corporation to individual shareholder 2. Transfer from corporation to corporate shareholder 3. Transfer from corporation to sister corporation 4. Transfer from individual shareholder to corporation

38 1. Transfer from Corporation to Individual Shareholder Tax consequences to corporation: Taxed on amount (if any) by which CSV exceeds ACB Actual sale proceeds (if any) irrelevant if non-arm s length Tax consequences to individual: Taxable benefit = FMV minus amount paid as purchase price or declared as dividend ACB = CSV at time of transfer but may also be ACB adjustment to recognize any shareholder benefit

39 2. Transfer from Corporation to Corporate Shareholder (A) Dividend in Kind Tax Consequences to Transferor Corporation: Taxed on amount (if any) by which CSV exceeds ACB Tax Consequences to Transferee Corporation: Tax free subject to safe income rules Taxable benefit if FMV>amount of dividend ACB = CSV at time of transfer but may also be ACB adjustment to recognize any shareholder benefit

40 2. Transfer from Corporation to Corporate Shareholder (B) Purchase Tax Consequences to Transferor Corporation: Taxed on amount (if any) by which CSV exceeds ACB Actual sale proceeds (if any) irrelevant if non-arm s length Tax Consequences to Transferee Corporation: Taxable benefit if FMV>purchase price ACB = CSV at time of transfer may also be ACB adjustment to recognize any shareholder benefit

41 3. Transfer from Corporation to Sister Corporation Tax Consequences to Transferor Corporation: Taxed on amount (if any) by which CSV exceeds ACB Actual sale proceeds (if any) irrelevant if non-arm s length Tax Consequences to Transferee Corporation: No taxable benefit ACB = CSV at time of transfer Tax Consequences to Shareholder of Transferee: Potential taxable benefit if FMV>purchase price

42 4. Transfer from Individual Shareholder to Corporation Tax Consequences to Individual: Taxed on amount (if any) by which CSV exceeds ACB Actual sale proceeds (if any) irrelevant if non-arm s length Tax Consequences to Corporation: ACB = CSV at time of transfer

43 4. Transfer from Individual Shareholder to Corporation Example: $1 million Universal Life policy issued in 1987 when insured (Bert) 50 years of age CSV and ACB both zero Policy valued at $600,000 by independent actuary in 2012 Value based upon variety of factors including poor health of insured

44 4. Transfer from Individual Shareholder to Corporation Example (continued): Bert sells the policy to his wholly-owned corporation (Bert Co.) for FMV Bert Co. satisfies purchase price with promissory note and/or cash (total $600,000) Bert s taxable income = CSV ACB = 0 Bert Co. s ACB = 0

45 4. Transfer from Individual Shareholder to Corporation Example (continued): On Bert s death Bert Co. receives $1 million tax free Bert Co. also receives CDA credit of $1 million (assuming no increase in ACB)

46 Lessons Tax rules are too onerous in some cases and too generous in others Planning should include steps to limit likelihood of future transfers from a corporation ownership at holding company level often recommended Legislative amendments long overdue

47 5. Transfers of Policies to Charity

48 Transfers to Charity Previous position in IT-244R3 value of donated policy equals CSV Change announced in 2007 value of donation is policy s FMV Taxable gain based on CSV not FMV Consider how future premiums to be paid

49 Transfers to Charity Beware of three year rule and ten year rule If policy acquired by donor less than three years prior to gift donation amount = ACB Same applies if policy acquired less than ten years prior to gift and if it s reasonable to conclude that one of the main purposes of acquiring the policy was to make a gift

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