Transferring a Corporate Life Insurance Policy to a Shareholder

Introduction

Many Canadian business owners hold permanent life insurance inside their corporation. Over time, circumstances change. The corporation may be sold, wound up, or restructured, or the shareholder may simply want to hold the coverage personally so that it sits outside the business.

Moving a policy out of a corporation and into the hands of a shareholder is not a neutral administrative step. It is a disposition for income tax purposes, and the rules that apply can produce a tax bill at the corporate level, at the shareholder level, or both.

There is currently no provision in the Income Tax Act that permits a tax deferred rollover of a life insurance policy into or out of a corporation. Every such transfer is a taxable event that must be measured and reported.

When Subsection 148(7) Applies

Subsection 148(7) of the Income Tax Act governs the transfer of an interest in a life insurance policy where the transfer is made by way of gift, by distribution from a corporation, by operation of law only, or in any manner to a person with whom the policyholder was not dealing at arm’s length.

A transfer from a corporation to its controlling shareholder generally falls within this rule, because the parties do not deal at arm’s length and because the transfer is typically effected as a distribution from the corporation.

The result is that the corporation cannot simply hand the policy over at a nominal amount. The Act substitutes a deemed amount for the proceeds, regardless of what the parties agreed between themselves.

The Deemed Proceeds Rule

For dispositions occurring after March 21, 2016, paragraph 148(7)(a) deems the transferring policyholder to receive proceeds of disposition equal to the greatest of three amounts.

The three amounts are:

• The value of the interest at the time of disposition, which subsection 148(9) generally defines as the cash surrender value
• The fair market value of the consideration, if any, given for the interest
• The adjusted cost basis of the interest to the policyholder immediately before the disposition

Paragraph 148(7)(b) then deems the person acquiring the interest to acquire it at a cost equal to that same amount.

Before March 22, 2016, only the first of these three amounts applied. The two additional measuring points were added by the 2016 federal budget legislation and significantly changed the planning landscape.

The Policy Gain to the Corporation

Once the deemed proceeds are determined, subsection 148(1) requires the corporation to include in income the amount by which those proceeds exceed the adjusted cost basis of the policy immediately before the disposition.

This amount is commonly called a policy gain. It is important to note that a policy gain is included in income in full. It is not a capital gain, and it does not receive the inclusion rate treatment that applies to capital property.

Where the adjusted cost basis is the greatest of the three measuring amounts, the deemed proceeds will equal the adjusted cost basis and the policy gain will be nil. This is a common outcome for policies in their earlier years, where the adjusted cost basis still exceeds the cash surrender value.

Where the cash surrender value has grown beyond the adjusted cost basis, which typically occurs in later policy years, a taxable policy gain will arise at the corporate level.

The Tax Consequence to the Shareholder

The shareholder side of the transaction is governed separately, and this is where the larger exposure usually sits.

Where the policy is transferred as a dividend in kind, subsection 82(1) applies. The value placed on a dividend paid in assets other than cash is the fair market value of those assets at the date of transfer. An individual shareholder includes that amount in income, subject to the gross up under paragraph 82(1)(b) and the corresponding dividend tax credit.

Critically, the fair market value of a life insurance policy is a different and generally much larger number than its cash surrender value. Fair market value reflects actuarial factors including the health and life expectancy of the insured, the guarantees in the contract, and the cost of replacing equivalent coverage.

Where the transfer is not structured as a properly declared dividend and the shareholder gives no adequate consideration, a shareholder benefit may instead be assessed under subsection 15(1).

A CRA Illustration of the Mismatch

The Canada Revenue Agency addressed this issue at the 2017 CLHIA roundtable using a worked example that illustrates the problem clearly.

In that scenario, a corporation owned a policy on the life of its shareholder with a cash surrender value of $500, an adjusted cost basis of $50,000, and a fair market value of $450,000. The policy was transferred to the shareholder as a dividend in kind for no consideration.

Applying paragraph 148(7)(a), the deemed proceeds to the corporation were $50,000, being the greatest of the cash surrender value, the nil consideration, and the adjusted cost basis. The resulting policy gain to the corporation was nil.

The shareholder was deemed under paragraph 148(7)(b) to acquire the policy at a cost of $50,000. At the same time, subsection 82(1) produced an income inclusion to the shareholder of $450,000, being the fair market value of the policy, plus the applicable gross up.

The shareholder therefore reported income based on a $450,000 value while carrying a tax cost in the policy of only $50,000. The CRA observed that it is not clear this outcome is intended as a matter of tax policy, and indicated it had referred the matter to the Department of Finance.

This mismatch remains the single most important feature of these transfers for business owners to understand before proceeding.

Loss of the Capital Dividend Account Credit

A further consequence is often overlooked at the planning stage.

Where a corporation owns a policy and receives the death benefit, the amount by which the proceeds exceed the adjusted cost basis of the policy is credited to the corporation’s capital dividend account. That credit can subsequently support a tax free capital dividend to shareholders.

Once the policy is held personally, the death benefit is paid to the individual’s named beneficiary. It is received outside the corporation and generates no capital dividend account credit.

For a business owner whose estate plan depends on extracting corporate value tax free at death, moving the policy out can quietly remove a significant planning advantage.

Premium Funding After the Transfer

The ongoing cost of the policy also changes.

Where the corporation pays premiums, it funds them from corporate after tax dollars taxed at corporate rates. Where the shareholder pays premiums personally, the funds must first be extracted from the corporation as salary or dividends and taxed at personal rates.

For many owners the after tax cost of maintaining the same coverage increases after a transfer to personal ownership. Life insurance premiums are generally not deductible in either case, subject to limited exceptions such as certain collateral assignment situations.

Valuation and Documentation

Because the shareholder level inclusion is driven by fair market value, the valuation of the policy is central to the transaction and is frequently the point of dispute on audit.

Fair market value is a question of fact. It is not the cash surrender value, and it is not a figure that should be estimated informally. An independent actuarial valuation prepared at the time of transfer is generally appropriate where the amounts involved are material.

Corporate records should document the transfer properly, including the directors’ resolution declaring any dividend in kind, and the insurer should be notified so that ownership is formally changed on the policy contract.

Common Planning Mistakes

Several errors recur in these transactions.

Some owners assume the cash surrender value governs the entire transaction and are surprised by a shareholder inclusion based on a far higher fair market value.

Others treat the transfer as a simple change of ownership form filed with the insurer, without any corporate resolution or tax reporting.

A further mistake is proceeding without obtaining a defensible valuation, which leaves the reported amount exposed to reassessment.

Finally, some owners complete the transfer without considering the loss of the future capital dividend account credit, which may be worth more than the immediate tax cost being avoided.

Conclusion

Transferring a corporate owned life insurance policy to a shareholder personally is a disposition governed by subsection 148(7) of the Income Tax Act. 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 of the policy, with any excess over adjusted cost basis included in corporate income in full as a policy gain. 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 may substantially exceed the cost the shareholder is deemed to acquire. There is no rollover available. Proper valuation, documentation and consideration of the capital dividend account consequences should all precede any decision to move a policy out of a corporation.

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.
Should you have any inquiries, please do not hesitate to contact us at (905) 836-8755, via email at info@taxpartners.ca, or by visiting our website at www.taxpartners.ca.
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