I’ve seen a number of transactions lately where the owner of a life insurance policy proposes to transfer it to a corporation controlled by the owner. The benefits of corporate-owned insurance are well-known, of course, but such a transfer could also permit the owner to withdraw significant amounts of money from the corporation tax free.
The transfer of a life insurance policy is not subject to the ordinary rules applicable to capital property, so that the rules on capital gains and losses do not apply. Moreover, a life policy cannot be transferred on a deferred basis to a corporation (a policy is not eligible property for the purposes of section 85 of the Income Tax Act (the ‘Act’)).
Where an individual disposes of a policy to a non-arm’s length corporation, the individual is deemed to receive proceeds equal to the value of the policy, and it is the difference between this value of the policy and its ‘adjusted cost basis‘ (not ‘adjusted cost base’) that must be included in income. With a non-arm’s length transfer, the value of the policy will be equal to its cash surrender value (‘CSV’), if the policy has one, or nil, if it does not. The basis is determined pursuant to a complicated formula in the Act, but it is, very generally, the premiums paid under the policy minus the ‘net cost of pure insurance’ (the cost of the insurance-only portion of the policy). If the fair market value of the policy—as determined by a actuary or the like—is higher than CSV, and CSV is higher than basis, then the transferor of the policy will realize a gain, but he or she will also be entitled to take back proceeds from the corporation in the form of a note equal to the fair market value of the policy, which might be well in excess of its value for tax purposes (its CSV). The tax cost of making the transfer might be more than offset by the tax benefits associated with being able to withdraw from the corporation funds equal to the principle amount of the note tax-free.
Is the CRA happy about the foregoing? The CRA has stated that it is unhappy; it referred the matter to Finance for consideration, which promised To Do Something. That was at least seven years ago.
In a technical interpretation released earlier this year, however, the CRA hinted darkly that subsection 15(1) of the Act or the GAAR could apply to a life policy transaction (see document number 2008-0303971E5, available in French only). Presumably subsection 15(1) would apply only if the corporation paid too much for the policy (by issuing notes with a total amount in excess of the fair market value of the policy), but the CRA seemed to think it would be relevant to know the identity of the beneficiaries of the policy and whether they were designated irrevocably. As for the GAAR, it is hard to see how it could apply if the transferor includes in income the amount required by the Act itself.
In the right circumstances, a transfer of a life policy would appear to permit a shareholder to withdraw significant amounts tax-free from a corporation, but some caution is warranted. The CRA, given its attitude, will likely review these transactions carefully, probably with an eye to whether the fair market value attributed to the policy is correct. Moreover, the CRA might lose patience with Finance and mount a GAAR challenge. That the challenge should fail will be no consolation to a client with better things to do than prosecute a Tax Court appeal.
