Tax implications when transferring ownership of a life insurance policy

Transcription

1 Tax implications when transferring ownership of a life insurance policy May 2015 Jean Turcotte, B.A.A., LL.B., CLU Director, Tax, Wealth & Insurance Planning Group Sun Life Financial

2 FOR ADVISOR USE ONLY Tax implications when transferring ownership of a life insurance policy Life insurance needs are not static. They change over time as a client s situation changes. When clients think about transferring ownership of a life insurance policy, many questions arise. What constitutes a disposition? Who is liable for the tax due, if any? Under what circumstances is a tax-free rollover available? What are the tax consequences of a transfer between a business corporation and a shareholder or employee? The tax implications in these situations are sometimes difficult to assess. There are legal and tax concerns. The questions and answers will vary depending on the parties involved in the transaction. This article will address some of these issues. We ve included some examples to help you understand the tax implications. The owner of the policy may choose to transfer their interest in a life insurance policy to another individual for a number of reasons. In Quebec, civil law allows the assignment of an insurance contract to a third party provided the assignee has an insurable interest in the life or health of the insured. If an insurable interest does not exist at the time of the transaction, the insured must consent to the assignment in writing. 1 Throughout this article when we say disposition or assignment, we mean transferring ownership these terms are used interchangeably. In some examples, payment will be made in return for transferring ownership. This payment is also referred to as consideration. References to specific legislative provisions are from the Income Tax Act, unless otherwise stated. What is a disposition? Transferring ownership of an interest in a life insurance policy is defined as a disposition in the Income Tax Act. The proceeds from the disposition may be higher or lower than the policy s cash surrender value (CSV) if the transaction involves unrelated persons. Subsection 148(7) contains specific rules that override the general rules governing life insurance policy dispositions. Subsection 148(7) applies if an interest in a life insurance policy is disposed of by: 1. gift, either while living or by will, 2. distribution from a corporation, 3. operation of law only to any person, whether at arm s length or not, or 4. transfer in any manner to any person with whom the transferor is not dealing at arm s length. The proceeds of disposition to the transferor and the new adjusted cost basis to the transferee are deemed to be equal to the value of the interest in the life insurance policy. Value is defined as the amount the policyholder would be entitled to receive if the policy were surrendered, net of policy loans, dividends payable and interest payable. 2 In most cases, the value will be the cash surrender value of the policy. Where a policy has no cash surrender value, this value is nil. Because life insurance policies don t fall into the tax category of capital property, a taxpayer who disposes of their interest in a life insurance policy doesn t realize a capital gain. Instead, it s a policy gain and 100% of the gain will be included in income. They won t be able to claim any losses to offset the gains. 1 Article 2418 of the Civil Code of Quebec. 2 See definition of value under subsection 148(9) of the Income Tax Act (ITA). Tax implications when transferring ownership of a life insurance policy Page 1

3 Adjusted cost basis (ACB) of a life insurance policy The concept of adjusted cost basis (ACB) is defined in the Income Tax Act. 3 The ACB is the cost of the interest the policyholder has acquired in a life insurance policy. This is the base value from which a policy gain is calculated. The ACB is calculated according to a complex formula in subsection 148(9). This amount may vary depending on: the acquisition date of the policy, the nature of the policy (which could be a life insurance policy or an annuity), and any transactions that have taken place on the policy, such as policy loans or the payment of dividends. It s increased by certain factors, such as the amount of premiums paid, and is reduced by others, such as the net cost of pure insurance (NCPI). 4 The amount representing the ACB of the policy may not be negative. If the ACB calculation produces a negative result, the policy s ACB will be nil. Information about the ACB amount is usually available through the insurer that issued the policy. Taxes payable by policyholder on transfer The insurer is required to indicate on a T4 or T5 slip the taxable amount the policyholder has to include in their income for the taxation year in which they transferred ownership. The policyholder must include the full amount of the taxable portion on their income tax return. 5 Depending on whether the parties are dealing at arm s length, there will be an additional factor to consider. In certain cases it will be necessary to determine the fair market value of the life insurance policy and if this represents a taxable benefit for the policyholder. Arm s length transactions The taxable income arising from a disposition can differ depending on the type of transaction involved and whether the parties are dealing at arm s length. When the parties are dealing at arm s length, the provisions of subsection 148(1) and the definition of proceeds of the disposition in subsection 148(9) apply. The disposition price is the amount that was paid and that the policyholder is entitled to receive. The amount to be included in the policyholder s income is calculated according to a formula in the Income Tax Act and is as follows for parties dealing at arm s length: Taxable policy gain = proceeds of disposition - adjusted cost basis of the policy (ACB) 3 See definition of adjusted cost basis under subsection 148(9) ITA; sections 976 and of the Taxation Act (TA). 4 Subsection 308(1) Income Tax Regulations. 5 Subsection 56(1)(j) ITA. Tax implications when transferring ownership of a life insurance policy Page 2

4 Non-arm s length transactions Persons who are not dealing at arm s length are those connected by blood relationship or marriage, as commonlaw partners or same-sex partners, or by adoption. Such a relationship may also exist between an individual and a corporation, a trust, or two corporations. 6 Specific rules outlined in subsection 148(7) apply. The amount the policyholder is entitled to receive is deemed to be the value of the policy. Subsection 148(9) states that the value is the cash surrender value of the policy minus any policy loans and without taking into consideration any dividends and interest payable on the loan. Where there is no cash surrender value, this value is nil. The amount to be included in the policyholder s income is calculated according to the following formula in the Income Tax Act and is as follows for parties not dealing at arm s length: Taxable policy gain = value of the policy - adjusted cost basis of the policy (ACB) Transfers between individuals There are many transactions in which individuals may be involved. A popular but mistaken belief is that a taxable disposition at death can be prevented by appointing a contingent owner on the policy. Transferring ownership to an individual, either during the policyholder s lifetime or at death, constitutes a disposition by operation of law. 7 The transfer will take place on a tax-free basis only if the contingent owner qualifies under the terms of the Income Tax Act as someone who is deemed to acquire the policy for an amount equal to its ACB. Transfers to a spouse There are two exceptions to taxing the policy gain resulting from the transfer between individuals. The first is a transfer between spouses, during the policyholder s lifetime or at death, if the policyholder and their spouse are residents of Canada at the time of the transfer. The definition of spouse includes married spouses, common-law partners, and same-sex partners. During the policyholder s lifetime, this definition also includes former spouses or common-law partners when the transfer is done to settle rights arising out of the marriage or common-law partnership. 8 Even though a transfer to a spouse doesn t have any immediate tax implications for the transferor, attribution rules need to be kept in mind. During the policyholder s lifetime, if the spouse accesses the cash surrender value via a policy loan or otherwise, it may cause the attribution rules to be applied to the income generated (unless the person is a former spouse). 9 There are certain situations that call for special attention. Firstly, common-law spouses who qualify as such under the Income Tax Act cannot be each other s heirs unless this is specifically provided for in a will or by means of a beneficiary designation in a life insurance policy. 6 Subsections 251(1) and 251(2) ITA; sections 18 and 19.1 TA. 7 Subsection 248(8) ITA; sections 7.1 and 7.2 TA. 8 Subsections 148(8.1) and (8.2) ITA; sections and TA. 9 Subsection 74.1(1) ITA; section TA. Tax implications when transferring ownership of a life insurance policy Page 3

5 The right of survivorship that applies to joint owners of an asset under common law 10 does not exist under civil law. In Quebec, the proportion of the interest in a life insurance policy held by one of the owners will automatically form part of that person s estate, even if the other owner is the spouse. The spouses have to appoint each other as the contingent owner of their interest in the policy, or ensure that there is a provision in their wills to address this situation. Transfers to a child The second exception to the rule taxing the policy gain resulting from a transfer is when the transfer is by a parent in favour of the child whose life is insured, or by a grandparent in favour of a grandchild whose life is insured or that person s parent. 11 Subsection 148(8) allows for a tax-free rollover to a child when: 1. the policy is transferred to the policyholder s child for no consideration, and 2. the life insured is a child of the policyholder or a child of the transferee. At first glance, this situation seems to be one that is easily applied. However, subsection 148(8), which allows tax-free rollovers, does not apply to an insurance policy transferred from parent to child by means of the policyholder s will. 12 On the policyholder s death, the policy will first be transferred to the estate, and then to the child. This situation will result in a disposition of the policy by the deceased policyholder, and any gain realized on the policy must be included in the deceased s final tax return. A life insurance policy, therefore, cannot be bequeathed in a will and qualify for a tax-free rollover. The only way around this is to name a contingent owner in the policy who is the insured child or a child of whom the insured is a child. In this way, tax will not be payable upon the policyholder s death. This type of transfer can be intricate, and clients should involve their legal and tax advisors. Transfers between two individuals Using the following information, let s look at the impact of a transfer between two individuals. Mr. A and Mr. B have run their company, ABC Inc., jointly for many years. Each personally owns an insurance policy on the life of the other using the criss-cross method. The objective is to ensure financial protection for each if either die prematurely. ABC Inc. has now ceased operations. They wish to transfer their respective life insurance policies to each other. Assuming the insurance policy owned by Mr. A on the life of Mr. B is as described below, the following are the tax repercussions of various transactions depending on if Mr. A and Mr. B are dealing at arm s length. In both cases, the amount paid for the policy by Mr. B is $65,000. Mr. A is the owner of an insurance policy on the life of Mr. B. Mr. B is a 57-year-old man in uncertain health. The policy details are as follows: 10 Generally, the right of survivorship is a right where, at death, the interest of the deceased joint owner is transferred to the surviving joint owner(s) by operation of law. For spouses residing outside Quebec, it is important to note that insurance policies should expressly stipulate that the right of survivorship applies. 11 The definition of "child" in this specific case is the definition found in subsection 148(9) ITA, which itself refers to the definition in subsection 70(10) ITA. 12 Confirmed by CRA technical interpretation no dated February 15, Tax implications when transferring ownership of a life insurance policy Page 4

6 Policy owner: Mr. A Insured: Mr. B Policy: Permanent life insurance policy Insurance amount: $1,000,000 Cash surrender value: $100,000 Adjusted cost basis: $65,000 Fair market value: $500,000 EXAMPLE If Mr. A and Mr. B are dealing with each other at arm s length If Mr. A transfers the insurance policy to Mr. B in return for a payment of $65,000, and they are dealing with each other at arm s length, the results are as follows: Proceeds of disposition for Mr. A $65,000 Adjusted cost basis for Mr. A $65,000 Taxable policy gain for Mr. A 0 There will be no amount for Mr. A to include in his taxable income as a result of the transfer. EXAMPLE If Mr. A and Mr. B are not dealing at arm s length If the parties are not dealing at arm s length, the Income Tax Act specifies the proceeds of disposition for Mr. A will be equal to the value of the policy, regardless of what amount is actually paid. This means the proceeds will be equal to the cash surrender value. The transaction has the following tax implications: Proceeds of disposition for Mr. A $100,000 Adjusted cost basis for Mr. A $65,000 Taxable policy gain for Mr. A $35,000 Mr. A would have to include a policy gain of $35,000 on his tax return as a result of the transfer of the policy to Mr. B. Transfers from a corporation to a shareholder or employee Corporations often own insurance policies on the lives of their shareholders and employees. In many cases, it s advantageous for the shareholder or employee to receive the policy after the corporation is sold or wound up, or after employment is terminated. The tax implications, however, will be different depending on whether the parties are dealing at arm s length. Tax implications when transferring ownership of a life insurance policy Page 5

7 Using the following information, let s look at the impact of a life insurance policy transfer from a corporation, ABC Inc., to Mr. S (shareholder), with whom it is not dealing at arm s length: Policy owner: ABC Inc. Insured: Mr. S (shareholder) Policy: Permanent life insurance policy Insurance amount: $1,000,000 Cash surrender value: $100,000 Adjusted cost basis: $65,000 Fair market value: $500,000 EXAMPLE Transfer from ABC Inc. to Mr. S Regardless of the amount of consideration paid for the policy, the transaction will take place for an amount deemed to be equal to the value, which will be the cash surrender value. If Mr. S pays $100,000 to ABC Inc., the tax impact for ABC Inc. would be as follows: Proceeds of disposition for ABC Inc. $100,000 Adjusted cost basis for ABC Inc. $65,000 Taxable policy gain for ABC Inc. $35,000 In addition, when Mr. S (shareholder) acquires his interest, the fair market value is higher than the cash surrender value. The tax impact for Mr. S. would be: Consideration paid by Mr. S $100,000 Taxable benefit for Mr. S $400,000 The CRA states that the shareholder or employee must include a taxable benefit in their income under the provisions of subsection 15(1) or paragraph 6(1)(a) for the year in which the transfer took place. The taxable benefit is usually equal to the amount the policy s fair market value exceeds its cash surrender value or the consideration paid 13 and must be added to the transferee s taxable income. 14 To prevent a taxable benefit from being conferred, the shareholder would have to pay the corporation an amount equal to the fair market value of the life insurance policy. 13 Confirmed by CRA technical interpretation F dated January 4, Confirmed by CRA technical interpretation dated January 13, Tax implications when transferring ownership of a life insurance policy Page 6

8 Transfers from an operating company to a holding company Corporate restructuring or the sale of an operating company will often lead to a change in the ownership structure of any life insurance involved. One common arrangement is for an operating company (OpCo) that is owned by a holding company (HoldCo) to transfer ownership of a life insurance policy to the holding company. The provisions of subsection 148(7) apply. EXAMPLE Transfer from OpCo to HoldCo The tax repercussions of this type of transfer would be as follows, depending on what amount HoldCo pays to OpCo for the policy. Scenario 1 Scenario 2 Scenario 3 Consideration paid Nil $100,000 (CSV) $500,000 (FMV) OpCo Proceeds of disposition $100,000 $100,000 $500,000 Adjusted cost basis $65,000 $65,000 $65,000 Taxable policy gain $35,000 $35,000 $435,000 HoldCo Taxable benefit $500,000 $400,000 Nil HoldCo could cancel out the taxable benefit by ensuring that the consideration paid reflects the fair market value of the life insurance policy and by declaring a dividend with a value equal to the fair market value of the policy ($500,000). The dividend could be treated as an inter-corporate dividend in kind. Interpretation Bulletin IT-67R3, Taxable dividends from corporations resident in Canada, explains the tax treatment that applies to dividends in kind. According to this Interpretation Bulletin, the dividend would be equal to the life insurance policy s fair market value even though the proceeds of disposition and the new ACB correspond to the policy s cash surrender value. However, if the dividend in kind is declared and paid before the sale of shares of the transferor corporation, subsection 55(2) may apply to deem the tax-free inter-corporate dividend to be a taxable capital gain. Transfers between sister corporations In the context of corporate restructuring, it might make sense to transfer a life insurance policy from one sister corporation to another. This type of transaction falls under the provisions of subsection 148(7). EXAMPLE Transfer between sister corporations Let s look at a situation where ABC Inc. owns an insurance policy on the life of a shareholder who is also a shareholder of DEF Inc. Following a restructuring of the business, ABC Inc. wishes to transfer this policy to DEF Inc. Below are the tax implications of this transaction, depending on the consideration paid by DEF Inc.: Tax implications when transferring ownership of a life insurance policy Page 7

9 Scenario 1 Scenario 2 Scenario 3 ABC Inc. DEF Inc. Proceeds of deemed disposition $100,000 $100,000 $100,000 Adjusted cost basis $65,000 $65,000 $65,000 Taxable policy gain $35,000 $35,000 $35,000 Consideration paid Nil $100,000 (CSV) $500,000 (FMV) Taxable benefit Nil Nil Nil New adjusted cost basis $100,000 $100,000 $100,000 In the above example, the two corporations are not shareholders of one another. As a result, there can be no taxable benefit for the transferee corporation under subsection 15(1). The CRA has, however, indicated that subsection 15(1) may apply if there is impoverishment (depletion of assets) of the transferor corporation and it can be demonstrated that as a result of the transfer, an economic benefit was conferred on the sole shareholder of the two corporations. 15 Transfer from a shareholder to a corporation For estate planning purposes, or as a result of corporate restructuring, a shareholder may wish to transfer their personally-owned life insurance policy to a corporation that they control. The shareholder and their corporation would not be dealing at arm s length, and subsection 148(7) applies. The shareholder (transferor) will be deemed to have disposed of their life insurance policy for proceeds of disposition equal to its value, which will generally be the cash surrender value. They will have to include the policy gain in their taxable income for the year, equal to the proceeds of disposition minus the ACB of the policy. In addition, if the shareholder can demonstrate that the fair market value of the life insurance policy is greater than its cash surrender value, they can receive consideration equal to this fair market value from the corporation on a tax-free basis. As long as the amount paid as consideration does not exceed the policy s fair market value, no taxable benefit will be conferred on the shareholder. Of course, this transaction will call for an independent valuation by a competent professional to determine the fair market value of the life insurance policy before proceeding with the transfer. 16 EXAMPLE Transfer from Mr. S to HoldCo The tax implications of this type of transfer are illustrated in the table below: 15 Round Table Taxation of Financial Strategies and Instruments, 2006 APFF Convention, Montreal, October 2006, Question 15; Tax Window Files, October 6, 2006, number C6. 16 In the technical interpretation a similar scenario was provided to the CRA for its comments. The CRA agreed with the tax results. In a more recent technical interpretation ( E5, dated May 27, 2009), CRA was again asked for its comments on the transfer of an insurance policy by an individual to his wholly owned corporation. CRA stated that the situation you have described in your request has, in fact, been brought to the attention of the Minister of Finance. Tax implications when transferring ownership of a life insurance policy Page 8

10 Mr. S transferor shareholder Proceeds of deemed disposition $100,000 Adjusted cost basis $65,000 Taxable policy gain $35,000 Tax (Assumed at 45%) $15,750 Net amount received $484,250 HoldCo Inc. transferee corporation Consideration paid $500,000 New adjusted cost basis $100,000 CDA credit $900,000 HoldCo will also be entitled to a credit to its capital dividend account (CDA) on payment of the death benefit, assuming it s the beneficiary of the policy. The credit to the CDA is equal to the death benefit minus the ACB of the policy. 17 For more details on this strategy, refer to the Sun Life Financial document entitled Transferring a life insurance policy to a corporation on the tax & legal section of the Sun Life Financial advisor website. 18 The new ACB of the policy for the corporation remains equal to the policy s cash surrender value (and not its fair market value). This lower ACB will increase the policy gains that can be realized in future if it is cashed in during the insured s lifetime. In return, it may also constitute a benefit, as the credit to the capital dividend account upon the death of the insured will also be higher. Transfers and amalgamations When two or more corporations are amalgamating and the provisions of section 87 apply, the new corporation is deemed to be the same corporation for each amalgamate corporation. As a result, the tax characteristics of the initial life insurance policy continue to apply. 19 This type of transaction would not be a disposition, given the continuation of the two amalgamated corporations. Transfers and corporate wind-ups When a corporation is being wound up and a subsidiary is absorbed by the parent corporation, the parent corporation, in respect of each subsidiary, is deemed to be the same corporation and a continuation of it under subsection 88(1). Therefore, if the applicable tax rules are followed, the initial life insurance policy could be transferred tax-free and the policy s adjusted cost basis would remain unchanged as a result Paragraph 89(1)(d) ITA CRA Interpretation Bulletin IT-474R, Amalgamation of Canadian Corporations, March 14, Technical interpretation , CALU, May 11, Confirmed by technical interpretation C6. Tax implications when transferring ownership of a life insurance policy Page 9

11 Determining the fair market value of a life insurance policy As we have seen, there are various situations that require determining a policy s fair market value. For example, the CRA has indicated that life insurance policies must be valued at their fair market value. We know that this value does not necessarily correspond to the policy s cash surrender value and that it will depend on several factors. CRA Information Circular 89-3 entitled Policy Statement on Business Equity Valuations outlines certain valuation principles. 21 According to these guidelines, there are a number of factors to be considered in correctly determining the fair market value of a life insurance policy, including: the policy s cash surrender value and face value the state of health and insurability of the insured and their life expectancy conversion privileges, riders and other provisions replacement value and the type of policy involved. Valuation of a policy s fair market value should always be carried out by an independent professional. Conclusion The tax implications of transactions performed on life insurance policies are often difficult to assess. Consequently, some situations will require clients to obtain actuarial and taxation specialists advice to ensure they are not exposed to an unexpected tax assessment. When in doubt, it s always best to have the transaction validated before proceeding with a transfer. Every effort has been made to ensure the accuracy and currency of the information provided. However, any examples presented in this article are for illustration purposes only. No one should act upon these examples or information without a thorough examination of the tax and legal situation with their own professional advisors after the facts of the specific case are considered. This article is intended to provide general information only. Sun Life Assurance Company of Canada does not provide legal, accounting or taxation advice to advisors or clients. Before a client acts on any of the information contained in this article, or before you recommend any course of action, make sure that the client seeks advice from a qualified professional, including a thorough examination of their specific legal, accounting and tax situation. Any examples or illustrations used in this article have been included only to help clarify the information presented in this article, and should not be relied on by you or a client in any transaction. Author: Jean Turcotte, B.A.A., LL.B., Lawyer, Director Tax, Wealth & Insurance Planning Group First published: August 2003 Last revised: May 2015 Sun Life Assurance Company of Canada, Sun Life Assurance Company of Canada is a member of the Sun Life Financial group of companies. 21 The CRA has stated that the valuation principles for a life insurance policy as set out in Information Circular IC89-3, sections 40 and 41, applied in all circumstances, and not only with respect to valuation in the context of a corporation. Tax implications when transferring ownership of a life insurance policy Page 10