25 February 2003 Internal T.I. 2003-0001677 - DEMUTUALIZATION CONVERSION BENEFIT

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:

Tax implications of demutualization proceeds received by an employer and partially passed through to employees where the deadline for filing an election under 139.1(16)(f)(iii) has passed.

Position:

General comments provided on application of section 139.1, to recipients of demutualization benefits.

Reasons:

Specific comments on the application of the provisions can only be provided where all the facts are known.

						February 25, 2003

XXXXXXXXXX  TSO		 				HEADQUARTERS
Business Enquiries					Financial Institutions Section
Verification & Enforcement Division			Income Tax Rulings Directorate
Attention:  XXXXXXXXXX 				Alison Campbell
(613) 957-3496

2003-000167

Demutualization Payments to Employees

We are replying to your request for assistance in determining the appropriate application of section 139.1 of the Income Tax Act, in respect of a particular taxpayer. Since the taxpayer's transactions are completed, we are not in a position to provide the taxpayer will a ruling as to how section 139.1 of the Act applies to their particular facts. The determination of the tax implications of completed transactions is within the mandate of the Tax Services Offices. We can however, provide comments to you that may assist your Tax Services Office in the interpretation of the relevant provisions of the Act as they may apply to a specific taxpayer situation. In this regard, we have the following comments.

All references to provisions in this memorandum refer to provisions of the Income Tax Act with Regulations (R.S.C. 1985 (5th supp.) c.1, as amended), unless otherwise indicated.

Demutualization Payment From an Insurer to a Stakeholder

Where an employer is the named policyholder of a group life insurance policy and the employees covered under the policy are certificate holders in respect of the policy, the insurer will generally make the demutualization payment to the employer. In a situation such as the one you are reviewing, the stakeholder referred to in the legislation would be the employer. Paragraph 139.1(2)(b) will apply in respect of the demutualization payment, provided the insurer made the payment to the employer at any time before the deadline for the payment. "Deadline" is defined in subsection 139.1(1), and is applicable to the timing of the payment from the insurer to the employer. XXXXXXXXXX Based on the definition of "deadline" in paragraph 139.1(1)(a), the "payment" referred to in 139.1(2)(b) will be considered to have been made before the deadline, provided XXXXXXXXXX made the payment of shares to the employer within 13 months of the date of its demutualization. Based on the facts provided to us, it would seem that the deadline was met and therefore paragraph 139.1(2)(b) would apply. Where paragraph 139.1(2)(b) applies, the employer, as a consequence of the payment from the insurer, will be considered to have received a benefit in respect of the demutualization at the time that the payment is received and not at the time that the employer became entitled to receive a demutualization payment.

Based on the letter from XXXXXXXXXX to the taxpayer, which was dated XXXXXXXXXX, the taxpayer received the demutualization benefit from XXXXXXXXXX in the form of cash, and not in the form of shares. This was either because of a choice to receive the benefit in the form of cash, or because under the terms of the demutualization plan the taxpayer was required to receive the benefit in cash. Where an employer receives a demutualization benefit in the form of cash, and it is not in respect of a life insurance policy held by any deferred plan (e.g. RRSP, RPP, DPSP RRIF) such that subsection 139.1(14) would apply, then subparagraph 139.1(4)(f)(ii) will deem the employer to have received a taxable dividend in the amount received from the insurer.

The application of subparagraph 139.1(4)(f)(ii) is subject to the application of subsection 139.1(16). If subsection 139.1(16) does not apply in a particular situation, the employer will include the amount of the taxable dividend in computing its income for the year, and would generally be able to claim a deduction under section 112 in respect of the amount of the dividend. If the employer decides to distribute some or all of the payment it received from the insurer to other persons, such as employees who were covered under the policy, and subsection 139.1(16) does not apply, the amount received by the individual, depending upon the particular facts, will generally be included in computing the individual's income. In many cases, the amount will be taxable under paragraph 6(1)(a) as a benefit received or enjoyed by the taxpayer in the year in respect of, in the course of, or by virtue of an office or employment.

Payment By Employer to Employees of Some or All of the Demutualization Amount Received by the Employer from the Insurer

Subsection 139.1(16) provides a flow-through of the tax effects relating to the receipt of a demutualization benefit where, for example, the employer that is the master policyholder under a group life insurance policy decides to pay out some or all of the demutualization benefit it received from the insurer, to the employees who were covered under the plan and bore at least some of the cost of the insurance premiums. In very general terms, subsection 139.1(16), when it applies, will deem the employer that received the payment from the insurer, not to have received the payment from the insurer, and will instead deem the employees who receive the payment from the employer to have received the payment directly from the insurer as a taxable dividend.

The conditions that must be satisfied for subsection 139.1(16) to apply are found in paragraphs (a) to (f) of the subsection. The conditions in paragraphs 139.1(16)(a) to (e), are fairly clear and whether they have been met will depend on the facts of the particular situation. Paragraph 139.1(16)(f) requires that one of four different conditions be met. Subparagraph 139.1(16)(f)(ii) would not apply in this particular situation as the employer will not have made the payment to the employees before December 7, 1999. Subparagraph 139.1(16)(f)(iv) applies where the payment from the employer would not result in the inclusion of the payment in the recipient's income if section 139.1 was read without reference to subsection 139.1(16). This may be the case in some instances where subsection 6(1) would not result in the amount being included in the individual's income. Where subparagraph 139.1(16)(f)(iv) applies to a payment to any particular individual, no election is required as the provision will automatically apply to the payment.

Where the payment is made by an employer (as stakeholder), after December 6, 1999, subparagraph 139.1(16)(f)(iii) will generally apply only in those situations where the employer filed in writing with the Minister, an election to have subsection 139.1(16) apply in respect of the payment within 6 months after the end of the employer's taxation year, in which the employer received the payment from the insurer. Subparagraph 139.1(16)(f)(iii) also requires that the employees, but for subsection 139.1(16), would have an income inclusion in respect of the receipt of the payment. In those circumstances where the employer did not file a timely election, the Minister may accept a late filed election to permit the application of subsection 139.1(16) to the payment from the employer to the employees. It will be up to your Tax Services Office to determine whether it is appropriate to accept a late filed election.

Subparagraph 139.1(16)(f)(i) will apply where the employee is resident in Canada when the payment is made, the employer is exempt from tax on its income under Part I of the Act and, but for subsection 139.1(16), the amount received would be included in computing the income of the employee. It is our understanding that the particular employer in your situation was exempt from tax on its income under Part I of the Act at the time that the demutualization benefit payment was received from the insurer. It is not clear however, whether the employer is still exempt from tax on its Part I income when the payment is to be made to the employees. We understand that the tax status of the employer may have changed because of a restructuring transaction that took place in XXXXXXXXXX. It is important that a determination be made of the tax status of the employer at the time of the payment to the employees, as this will affect the tax consequences of the payment.

It is our view that subsection 139.1(16), when it applies, relates to the payment from the employer as stakeholder to the employees and therefore it is the employer's tax status at the time it flows the payment through to the employees that is relevant in determining whether subparagraph 139.1(16)(f)(i) applies. Accordingly, if the employer is exempt from tax on its Part I income at the time it makes the payment to the employees, subparagraph 139.1(16)(f)(i) will cause subsection 139.1(16) to apply without the need for an election (assuming the facts support a finding that all the other conditions for subparagraph (i) to apply are also met). However, if the employer is not exempt from tax on its Part I income at the time it makes the distribution to the employees, subparagraph 139.1(16)(f)(i) will not apply, and where subparagraph 139.1(16)(f)(iv) does not apply and the Tax Services Office has not considered it appropriate to extend the election deadline so that subparagraph 139.1(16)(f)(iii) applies, as discussed above, the flow-through treatment under subsection 139.1(16) will not be available.

Where the Conditions for Applying Subsection 139.1(16) Are Met

Paragraphs 139.1(16)(g)-(l) set out the rules that apply if the conditions in paragraphs 139.1(16)(a)-(f) are met. In general terms, where the rules apply in a situation similar to that which you are reviewing, the employees will be deemed pursuant to paragraph 139.1(16)(i), to have received dividends paid to them on the capital stock of the insurer, in the amount so received. These would be dividends from a taxable Canadian corporation and subject to the dividend gross-up and dividend tax credit. The employer would be deemed pursuant to paragraph 139.1(16)(k) not to have received the demutualization payment from the insurer to the extent of the fair market value of the payment made to the employees. Paragraph 139.1(16)(g) provides that the employer will not be permitted to deduct any amount of the demutualization benefit payment that it flows through to the employees. In general terms, the employer will have a taxable dividend with respect to the amount of any demutualization payment it received, but does not pay out to the employees, and the employees will be considered to have received taxable dividends in the amount of the demutualization benefit flowed through to them by the employer. The employer will also be responsible for the preparation of a T5 return, and the issuance of T5 reporting slips to each employee that received a payment, reporting the amount of the dividends deemed to have been paid to the employee pursuant to paragraph 139.1(16)(j).

Summary on Application of Subsection 139.1(16)

The foregoing analysis can be summarized in a very general way as follows:

Assuming paragraphs 139.1(16)(a) to (e) are satisfied,

A. Any payment to an individual described in subparagraph 139.1(16)(f)(iv) will be automatically fall within the scope of subsection 139.1(16), regardless of whether an election had been filed, or whether the employer is exempt from Part I tax at the time it makes the payment to the individuals. With respect to the amount of these payments from the demutualization benefit, the employer will not have any income inclusion (139.1(16)(k)), nor will it be entitled to a deduction (139.1(16)(g)), and the individuals will be deemed to have received a taxable dividend (139.1(16)(i)).

B. Where the employer makes a payment to an individual at a time that the employer is exempt from tax on its Part I income and the other conditions in subparagraph 139.1(16)(f)(i) are satisfied, subsection 139.1(16) will apply to the payment. No election is required to be filed. The tax consequences to the employer and the individual in respect of such payments will be the same as the tax consequences in A above.

C. Where the employer is not exempt from tax on its Part I income at the time it makes a payment to an individual, subparagraph 139.1(16)(f)(iv) does not apply to the payment and the Tax Services Office considers it appropriate to extend the election deadline so that subparagraph 139.1(16)(f)(iii) applies, the tax consequences of the payment to the employer and the individual will be the same as in A and B above.

D. Where the payment of part of the demutualization benefit by the employer to an individual does not fit within either subparagraph 139.1(16)(f)(i) or (iv) and the Tax Services Office does not consider it appropriate to extend the election deadline such that subparagraph 139.1(16)(f)(iii) will be applicable subsection 139.1(16) will not apply to the payment. Instead, the employer will have a taxable dividend included in its income, a dividend deduction under section 112, and possibly a deduction for the amount of the payments as a cost incurred in the course of carrying on business. Those employees who receive payments not covered by subsection 139.1(16), will generally be considered to have received the payment from their employer in the course of or by virtue of an office or employment and will be fully taxable on the amount.

Other Comments

In providing our comments above, we have assumed based on the facts we have, that the demutualization benefit conferred by the insurer did not relate to a policy held in a pension plan or other deferred income plan. We have also assumed that all of the benefits were paid out by the insurer and that no amount in respect of the demutualization benefit is being reinvested to enhance the group policy or to fund policy premiums.

The copy of the agreement which you forwarded to us, indicates that the employer will be giving the amount of the distribution that relates to unionized employees to the union for distribution. It appears to us that the union is not a "recipient" of any amount of the demutualization benefit flow-through but is simply acting as an agent of the employer in the distribution of the payments that are to be made to the unionized employees. We advise that you verify that the union is merely an agent for distribution of the funds and is not retaining or re-directing any of the funds, as the retention or re-direction of the funds to anyone other than the appropriate employees may have tax implications beyond those addressed in this memorandum.

We also note that $XXXXXXXXXX of interest income was paid by XXXXXXXXXX to the employer as a consequence of the demutualization benefit amount being held in a depository account with XXXXXXXXXX pending the outcome of the negotiations between the employer and the union. The foregoing discussion on the application of section 139.1, does not apply to this interest amount. The interest would be included, as interest income, in computing income of the employer for the year. Where the employer disburses the interest to the employees, it is our view that in most cases, employee would be required to include the full amount in computing their income under paragraph 6(1)(a).

Finally, if the corporate employer is a subsidiary of a corporation that is owned by a municipality, it may be exempt from tax on its Part I income pursuant to subsection 149(1)(d.6) which applies in respect of corporations all of the capital or all of the shares of which are owned by a corporation that is a municipal corporation as defined by paragraph 149(1)(d.5).

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

We hope that the above comments are of assistance to you.

F. Lee Workman
Manager
Financial Institutions Section
Income Tax Rulings