7 May 2002 External T.I. 2002-0127505 - SUBSTITUTE LIFE POLICIES

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: What changes in the terms and conditions of an insurance policy would not result in a disposition of the insurance contract for tax purposes?

Position: Will depend upon whether the changes are so fundamental as to result in the creation of a new policy.

Reasons: Question of fact.

CALU Conference 2002

Question #5

Substitute Life Policies

Some life insurance policies contractually provide for the substitution of one life insured for another. In providing such a contractual provision, life insurers are relying on both contract law and paragraph 148(10)(d) of the Act, which states that a policyholder is not deemed to have disposed of, or acquired an interest in, a life insurance policy as a result of only exercising any provision of the policy, other than the conversion of the policy into an annuity contract. Policies which contain substitute life provisions are used, as an example, in corporate-owned life insurance situations where the life insured is a key person. If the key-person leaves the company's employment and a new individual is hired, the new individual can be substituted as the measuring life under the contact without the disposition of the former contract and the issuance of a new policy.

During the past year, the CCRA has issued two interpretations which call into question substitute life policies, notwithstanding that the substitution of one measuring life for another is specifically allowed in the contract wording. The first interpretation was issued on January 26, 2001 (document 2000-002117) and the second on December 3, 2001 (document 2001-009612).

The first interpretation request dealt with a hypothetical universal life policy which provided for multiple-life coverage and for the addition of one or more life insureds after the policy was issued. In this instance, the policyholder wished to change the terms of the policy and add coverage on himself and his wife on a joint-and-last survivor basis and then drop the individual life coverages on each of them after the joint coverage was added.

The CCRA's response noted that it would not view the addition of insurance on individuals on a joint-last-to-die basis to be insurance on different lives because the joint coverage was in respect of the same lives that were already insured under the policy. The response went on to note that because the hypothetical situation being considered in the letter would not, in the CCRA's view result in a disposition of the contract, the existence of a contractual right to substitute life insureds, would not be relevant.

The December 3, 2001, opinion dealt specifically with a substitution of the life insured. While it appears that the CCRA did not have the opportunity to review specific contract wording, it nevertheless offered some general comments. The response noted that the provisions of paragraph 148(10)(d) of the Act were intended to apply in cases where the policyholder has exercised certain contractual provisions. However, the reply went on to state it was the CCRA's view that this provision was not intended to allow the renegotiation of any of the terms of a policy or the addition of terms and conditions at a later date. From the reply, it appears that the CCRA would consider the substitution of the life insured as causing the renegotiation of the contract as it would necessitate other changes, such as a change in the premium structure of the contract. (It should be noted that in the situation referred to above, a change from insurance individual lives to a joint-and-last-survivor coverage would also have resulted in a premium change.) The reply stated that such changes may be sufficiently material as to cause the surrender of the original policy and the issuance of a new policy.

Both opinions use the term "sufficiently material" as the determining factor for whether a new contract would be created. This term is extremely subjective.

Question:

In light of these interpretations, can the CCRA provide some guidance as to what changes in the terms and conditions of the policy would not result in a disposition of the contract?

Agency's Response

It is a question of fact whether a change to the terms and conditions of a life insurance policy is so fundamental as to result in the acquisition of a new policy. Such a determination can only be made after reviewing all the facts on a case by case basis. A determination would require the consideration of the law of contracts since an insurance policy is a legal contract. It would be necessary to determine whether the alteration of the agreement constitutes a variation of the existing agreement such that the original agreement survives, or whether the alteration is so fundamental that it results in the creation of a new contract between the parties and the extinguishment of the original agreement. There are several tax cases which have addressed the alteration of contracts between parties and whether the alterations have resulted in the creation of new contacts. These cases are Ronald J. Weibe et al, v. Her Majesty the Queen (87 DTC 5068) and John A. Amirault v. The Minister of National Revenue (90 DTC 1330), and the recent Federal Court of Appeal decision in General Electric Capital Equipment Finance Inc. v. the Queen (2002 DTC 6734).

The caution that we were attempting to provide in the two documents referred to in the question is that paragraph 148(10)(d) of the Act was never intended, nor do we believe provides, for the non-disposition of an insurance policy by simply recognizing that the policy may be materially changed. This would be the case where for example I take out a life insurance policy on the life of my son and simply make provision that at some future date I can substitute my life for my son's. In such a case consideration would also have to be given with regard to the determination of whether such a policy would qualify as exempt. If sufficient detail was provided in the policy such that no negotiation or renegotiation of the terms and conditions of the policy would be required in connection with the substitution, the exercise of the right of substitution provision may not result in a disposition.

We recognize our comments are subjective and have brought this matter to the attention of the Department of Finance for their consideration. In the meantime we are prepared to consider any particular arrangements you are proposing on a case by case basis.