Corporate-Owned Life Insurance in Canada: Tax Treatmen

Introduction

Many Canadian private corporations own life insurance on the lives of their shareholders, key employees, or both.

The reasons vary. Some policies fund buy-sell agreements. Some cover the tax liability that arises on a shareholder’s death. Some protect the business against the loss of a key person. Some are held primarily for accumulation.

The tax treatment differs from personally owned insurance at almost every stage, and the differences are not intuitive. Premiums are treated one way, growth another, access during life a third, and the death benefit a fourth.

This article works through the treatment at each stage of corporate ownership.

Premiums Are Generally Not Deductible

The starting position is that life insurance premiums are not deductible, whether paid by an individual or a corporation.

A corporation paying premiums is therefore using after tax dollars. The advantage relative to personal ownership is not deductibility but rate. Corporate income taxed at small business rates is generally taxed more lightly than personal income, so funding premiums corporately usually requires less pre-tax income than funding them personally.

That advantage can be significant over a long premium paying period. It is a rate advantage, not a deduction.

A narrow exception exists under paragraph 20(1)(e.2), where a policy is assigned as collateral for a loan from a restricted financial institution and specific conditions are met. The deductible amount is limited and the conditions are specific.

Growth Inside the Policy

While the policy remains exempt, growth in cash value is not subject to annual accrual taxation. This is the same treatment that applies to personally owned policies.

For a corporation, this carries an additional consequence worth noting.

Because the growth is not included in the corporation’s income, it does not form part of the corporation’s investment income for the year. Corporations managing exposure to the passive income rules that grind the small business deduction sometimes find this feature relevant when comparing an exempt policy against a taxable corporate portfolio.

This should not be the primary reason to purchase insurance. It is a feature of a product bought for other reasons.

Accessing Cash Value During Life

The rules here are the same as for any policy, applied to a corporate policyholder.

A policy loan is a disposition under subsection 148(9), and a policy gain arises where the proceeds exceed the adjusted cost basis. That gain is included in the corporation’s income in full.

A surrender or partial surrender produces the same result, with subsection 148(4) prorating the adjusted cost basis on a partial disposition.

An assignment of the policy as collateral for a third party loan is excluded from the definition of disposition and does not produce a policy gain at the time of borrowing.

The important additional dimension for a corporation is what happens next. Funds extracted from the policy are inside the corporation. Getting them into the shareholder’s hands is a separate step with its own tax cost.

The Death Benefit and the Capital Dividend Account

This is where corporate ownership produces its distinctive advantage.

Where the corporation owns the policy and receives the death benefit as a consequence of the death of the life insured, the proceeds are received free of tax under an exempt policy.

The amount by which those proceeds exceed the adjusted cost basis of the policy to the corporation is credited to the corporation’s capital dividend account under paragraph 89(1)(d).

That credit can then support a capital dividend, paid free of tax to Canadian resident shareholders, following an election under subsection 83(2) on Form T2054.

The result is that a death benefit can pass from the corporation to the shareholder’s estate largely without tax, which is not achievable with most other corporate assets.

Adjusted cost basis reduces the credit. Because it declines in later policy years as the net cost of pure insurance accumulates, a long held policy generally produces a larger credit than a recently issued one.

Who Owns and Who Benefits

The structure of ownership and beneficiary designation drives the result, and errors here are common.

For the capital dividend account credit to arise, the corporation must receive the proceeds. Arrangements in which one corporation pays the premiums while a different entity is named beneficiary can produce an unexpected outcome.

Amendments announced in 2016 addressed structures that produced a full credit in a beneficiary corporation that had no adjusted cost basis in the policy, and reduced the credit in certain cases where a policy had been transferred into a corporation in earlier years.

Ownership and beneficiary designations across related corporations should be reviewed rather than assumed to be correct, particularly in groups that have reorganized since the policies were issued.

Shareholder Benefit Exposure

Where a corporation pays for insurance that benefits a shareholder personally, subsection 15(1) is engaged.

The typical fact pattern is a corporation paying premiums on a policy owned personally by the shareholder, or on a policy where the shareholder’s family members are named as beneficiaries. The value conferred can be assessed as a shareholder benefit and included in the shareholder’s income with no offsetting deduction to the corporation.

The same exposure arises where a corporate asset is used to support personal borrowing without adequate consideration.

These issues are straightforward to address at the outset and difficult to repair afterward.

Getting the Policy Out Later

Circumstances change, and corporations are sometimes sold, wound up, or restructured in ways that make continued corporate ownership unsuitable.

Moving a policy from the corporation to the shareholder is a disposition governed by subsection 148(7). The corporation is deemed to receive proceeds equal to the greatest of the cash surrender value, the fair market value of any consideration given, and the adjusted cost basis.

Where the transfer is effected as a dividend in kind, the shareholder includes the fair market value of the policy in income under subsection 82(1), an amount that typically far exceeds the cash surrender value.

No rollover is available in either direction. This is a reason to decide on ownership before the policy is issued.

Leveraged Arrangements and the 10/8 Rules

Corporations considering leveraged insurance arrangements should be aware that two structures were specifically shut down in the 2013 federal budget.

The first is the 10/8 arrangement, broadly involving a policy used to secure borrowing from the same insurer, generating a long running interest deduction. The measures deny the deductibility of interest and of premiums relating to the policy, and restrict the capital dividend account credit where the policy is corporate owned. In-force arrangements were not grandfathered.

The second is the leveraged insured annuity, addressed through the concept of an LIA policy. Where the rules apply, income in the policy is taxed annually rather than benefiting from exempt treatment, premium deductions are denied, and no capital dividend account credit arises on the death benefit. Arrangements where all borrowings were entered into before Budget Day were not affected.

Ordinary collateral lending against a policy was not eliminated by these measures. The rules target specific structures with specific features.

Creditor Exposure

A non-tax point that belongs in the analysis.

A policy owned by an operating corporation is an asset of that corporation and is exposed to its creditors. A policy held in a holding company sits further from operating risk.

This consideration often points toward holding company ownership, which then needs to be reconciled with where the premiums can most efficiently be funded and where the capital dividend account credit is most useful.

Common Planning Mistakes

Several errors recur.

Paying premiums from the operating company while naming a different entity as beneficiary, without confirming the capital dividend account consequence.

Having the corporation pay premiums on a personally owned policy, creating shareholder benefit exposure.

Calculating an expected capital dividend account credit on the full death benefit rather than the proceeds less adjusted cost basis.

Leaving ownership unreviewed after a corporate reorganization, so the structure no longer matches the original plan.

Assuming a policy can be moved out of the corporation later without tax cost.

Conclusion

Corporate-owned life insurance is treated differently from personally owned insurance at each stage of its life.

Premiums are generally not deductible, with a narrow collateral exception under paragraph 20(1)(e.2), so the advantage of corporate funding is the corporate tax rate rather than a deduction.

Growth inside an exempt policy is not subject to annual accrual taxation and is not included in corporate income.

Lifetime access through a policy loan or surrender is a disposition producing a fully taxable policy gain, and the funds then sit inside the corporation.

At death, the proceeds are received free of tax and the excess over adjusted cost basis credits the capital dividend account under paragraph 89(1)(d), supporting a tax free capital dividend to Canadian resident shareholders.

Ownership and beneficiary designations determine whether that credit arises, shareholder benefit exposure under subsection 15(1) must be managed, and moving a policy out of the corporation later is a taxable disposition with no rollover available.

These decisions should be made before the policy is issued, and reviewed whenever the corporate group is reorganized.

Tax Partners can assist you in structuring your affairs properly and ensuring full compliance while optimizing your tax position.

This article is written for educational purposes.
 

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