The 2016 Federal Budget announced changes that will impact the Capital Dividend Account and transfers of life insurance policies between shareholders and corporations.
Prior to these changes, there was a significant tax planning opportunity for shareholders of closely-held companies to transfer personally-owned policies to their corporations in exchange for proceeds equal to the policy’s Fair Market Value. For tax purposes, the disposition of a life insurance policy will give rise to a taxable policy gain arises to the extent that the CSV exceeds the policy’s Adjusted Cost Base (ACB). It’s important to note that a policy’s fair market value may vary greatly from it’s Cash Surrender Value (CSV), as determined by an independent actuary. As a result, shareholders had the potential in certain situations to extract substantial amounts of capital out of their corporations largely on a tax-free basis.
Example
John is 73 and he is the sole shareholder of JohnCo Holdings. He also owns a $1 million permanent life insurance policy with a cash surrender value of $100,000 and an ACB of $75,000. A few years ago John suffered a heart attack and he is considered uninsurable today. Based on the facts of his policy, an independent actuary values John’s policy at at fair market value of $400,000.
John could sell his policy to JohnCo Holdings for $400,000 without a shareholder benefit arising. On disposition of his policy, John would realize a taxable policy gain (fully taxable) of $25,000 ($100,000 – $75,000). As a result of this transaction, John would be able extract $400,000 from his corporation in exchange for roughly $12,500 in personal income tax (assuming a 50% tax rate). JohnCo Holdings would become the new owner and beneficiary of the $1million policy. Upon John’s death, the policy proceeds would be paid to the corporation, creating a credit to the corporation’s Capital Dividend Account (CDA) equal to the Death Benefit less the ACB. Generally, the ACB of a policy will reduce to nil by the insured’s life expectancy resulting in 100% of the death benefit being credited to the Capital Dividend Account. In John’s case, this will likely mean that the $1million death benefit will also be able to flow out of his corporation to his family on a tax-free basis.
New Rules
The 2016 budget has taken direct aim at this loophole by changing the way in which similar policy transfers will take place between shareholders and corporations. Moving forward, the deemed proceeds on a policy disposition will be considered to be equal to the FMV consideration paid or the Cash Surrender Value, whichever is greater. In the above example, this would mean that John would be subject to a taxable policy gain of $325,000 ($400,000-$75,000).
To complicate things further, the government will be applying this change retroactively. For policy transfers that took place between 1999 and March 22, 2016 the CDA credit received on death will be effectively reduced by the “tax-free” amount that was received by the shareholder from the corporation.
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