20 November 2003 Internal T.I. 2003-0029377 - LIFE INSURANCE COLLATERAL ASSIGNMENT

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:

1. Whether the assignment of a corporation's life insurance policy to a bank as partial security on a debt was a collateral or absolute assignment.

2. Whether life insurance proceeds received by the estate of the guarantor of the debt are taxable.

Position:

1. Question of law. In this case, the documentation provided suggests that the assignment of the life insurance policy was intended to be a collateral assignment.

2. If the guarantor had not died, the proceeds would have been taxed as a capital gain.

Reasons:

1. Documentation provided to us by the TSO.

2. Based on the premise that the original assignment to the bank was a collateral assignment, the bank transferred all its rights and interest in the policy to the guarantor when the guarantor paid the corporation's debt to the bank. The guarantor had claimed allowable business investment losses in respect of the amounts paid. Therefore, the life insurance proceeds would be considered a recovery of a bad debt and subject to tax as a capital gain. However, in this case, the guarantor died prior to receiving the proceeds with the result that paragraph 70(5)(a) would apply to deem the capital debt to have been disposed of for proceeds equal to fair market value.

								November 20, 2003

	XXXXXXXXXX  TSO						HEADQUARTERS
Financial Institutions Section
	Attention:  XXXXXXXXXX 					J. Leigh
	                  Audit Division					(613) 952-1505

								2003-002937

XXXXXXXXXX - Life Insurance Proceeds

This is in reply to your memorandum of July 11, 2003 regarding the tax treatment of life insurance proceeds received by the estate of XXXXXXXXXX ("Taxpayer") in XXXXXXXXXX. In particular, you requested our views on whether the life insurance policy was collaterally or absolutely assigned to the Taxpayer and whether the life insurance proceeds are subject to tax.

The relevant facts of the situation, as we understand them, are as follows:

1. In XXXXXXXXXX ("Corporation") acquired a convertible term life insurance policy on the life of its president. The Corporation was the policyholder and the beneficiary under the policy.

2. On XXXXXXXXXX, the Corporation assigned the life insurance policy to the XXXXXXXXXX ("Bank") as partial security on certain debts it owed to the Bank.

3. On XXXXXXXXXX, the Corporation, as the policyholder, applied to convert the policy into a select whole life policy with a policy date of XXXXXXXXXX. The table of guaranteed values prepared at the time showed a cash value of nil on XXXXXXXXXX.

4. XXXXXXXXXX.

5. The Taxpayer was required by the Bank to honour the guarantees and he claimed the amounts paid as allowable business investment losses in XXXXXXXXXX and XXXXXXXXXX.

6. XXXXXXXXXX.

7. On XXXXXXXXXX, the Bank assigned all its right, title, interest and benefit in and to the life insurance policy to the Taxpayer since the Taxpayer, as guarantor, paid the Corporation's debts to the Bank.

8. The terms of the policy provided for the premiums to be payable by the policyholder (i.e., the Corporation) until the death of the life insured. In addition, there was a rider on the policy providing for a waiver of premiums during the life insured's permanent total disability. The insurer has advised that no premiums were paid between the time the policy was assigned to the Taxpayer and the death of the life insured as a total disability claim was in effect providing for a waiver of premiums.

9. The life insured died on XXXXXXXXXX and the insurer paid proceeds of $XXXXXXXXXX plus interest of $XXXXXXXXXX to the Taxpayer's estate in XXXXXXXXXX. The amount of $XXXXXXXXXX was reported on the estate's XXXXXXXXXX T3 return as interest income.

10. The Taxpayer died in XXXXXXXXXX.

Audit's position

You have proposed to treat the life insurance proceeds as a recovery of a bad debt. In your view, the amount received should be included in income on capital account since the Taxpayer had claimed an allowable business investment loss for the amounts he paid to honour the guarantees he made to the Bank.

Taxpayer's position

The representative points out that allowable business investment losses were claimed by the Taxpayer in XXXXXXXXXX and XXXXXXXXXX as the Corporation's debts constituted capital property to the Taxpayer. XXXXXXXXXX.

With regard to the life insurance policy, the Taxpayer was assigned the policy XXXXXXXXXX. Since it is the representative's view that the assignment was also in settlement of an outstanding debt, he considered the assignment to be an absolute assignment. The insurer has advised the representative that it shares this view based on the assignment document. As the absolute owner of the policy, the representative submits that the proceeds were received by the Taxpayer's estate as a death benefit and therefore not subject to tax.

Our comments

Since the losses claimed by the Taxpayer are not under review, you have asked that we limit our comments to the two issues you raised.

In Norwood on Life Insurance Law in Canada (Third Edition), on page 362, it states that "an assignment which transfers the assignor's entire interest in the policy leaving no residual is known as an absolute assignment. One which leaves a residual interest with the assignor, even though the assignee's interest must first be satisfied in full, is known as a collateral assignment."

Whether a particular life insurance policy is collaterally or absolutely assigned is a question of law. The nature of the assignment will depend on the intent of the assignee and the assignor. Subject to any other evidence of intent, the assignment instrument is key in determining the nature of the assignment since it sets out the specific rights assigned.

In this case, the Taxpayer, as a guarantor of the Corporation's debt to the Bank, paid the debt of the Corporation and the Bank, in turn, transferred the security it held (i.e., the assignment of the life insurance policy) to the Taxpayer. Pursuant to the XXXXXXXXXX assignment document, the Bank assigned all its right, title, interest and benefit in and to the policy to the Taxpayer. Since the Taxpayer acquired all of the Bank's rights and interest in the policy, it is necessary to determine what those rights and interest were. In this regard, you have provided us with a copy of an assignment dated XXXXXXXXXX. Pursuant to this assignment, the Corporation assigned to the Bank:

"...XXXXXXXXXX ..."

At face value, it would seem arguable that the wording of this instrument suggests that ownership rights in the policy were transferred to the Bank. In fact, the insurer concluded that the particular assignment was an absolute assignment given the language used. The insurer commented that for all intents and purposes, the assignee in this particular assignment assumed the rights of a policyowner and of a beneficiary until such time, if ever, that the assignment is released. This seems inconsistent with the fact that subsequent to the assignment of the policy to the Bank, it was the Corporation and not the Bank that converted the policy to a whole life policy.

We note that the additional documentation provided by the representative on October 8, 2003 included a copy of a "policy agreement" and an assignment instrument relating to another life insurance policy that was also assigned by the Corporation to the Bank on XXXXXXXXXX. While the policy agreement for the particular policy could not be found, the representative has advised that it would have been similar to the one submitted. It appears that the Bank's practice was to require both forms to be completed for each life insurance policy assigned to it and it further appears that the Bank had standard forms that it used for this purpose given that the same standard assignment form was used for the two policies.

We will premise our comments as being on the assumption that a standard policy agreement form in respect of this particular life insurance policy was executed on XXXXXXXXXX. The standard policy agreement indicates that the assignment is security for the indebtedness to the Bank and includes terms such as the following:

? the assigned property will be a continuing security to the Bank for all present and future indebtedness of the policyowner;

? the policyowner, without the written consent of the Bank, cannot change the name of the beneficiary, cannot assign or otherwise dispose of the policy and cannot change the insurance plan which the policy is assigned to the Bank;

? the policyowner will pay all premiums on the policy as they become due and payable and will do all other acts which are necessary to keep the policy in full force;

? if the policyowner fails to pay the premiums, the Bank may pay the premiums but the premiums paid by the Bank with interest at XXXXXXXXXX% will be a charge on the policy;

? if the customer defaults in payment of any obligation to the Bank, the Bank may sell, dispose of, or otherwise realize upon the policy, or it may surrender the policy or accept a paid-up policy in lieu thereof;

? the policyowner and the beneficiary appoint any officer of the Bank to be their true and lawful attorney who, irrevocably in the name and on behalf of the policyowner and beneficiary, can endorse, assign and transfer to the Bank the policy and their right, title, interest and benefit in and to the policy;

? the beneficiary consents to all the provisions of the agreement and agrees that the Bank may make agreements and other arrangements with the customer or any other person with reference to the indebtedness or liability of the customer as the Bank may see fit.

In determining the nature of the assignment to the Bank, it is our view that both the policy agreement form and the assignment form must be read together as they are part of one assignment instrument. Notwithstanding the language used in the assignment form, it is our view that the more detailed policy agreement reflects the intention of the parties as to the nature of the assignment. The policy agreement seems to recognize that the rights in the policy remain with the policyholder and the beneficiary and therefore serves to set out the specific rights of the Bank. If the Bank were the absolute owner, there would not be a need to do so. Also, the fact that the policyholder (i.e., the Corporation) had the obligation to continue to pay the premiums is a further indication that the intent was a collateral assignment rather than an absolute assignment. In summary, it seems rather clear from the policy agreement that the policy was conveyed to the Bank by way of a collateral assignment.

This is consistent with what actually transpired. Essentially, the Bank required security for lending funds to the Corporation. The policy was assigned to the Bank as partial security. The Bank fully expected the Corporation to repay its debt in accordance with the terms of the debt. When the Corporation was unable to pay, the Bank chose to issue a demand to the Taxpayer to honour his guarantees rather than realize upon its security.

Regarding the taxability of the proceeds, as indicated in paragraph 4 of Interpretation Bulletin IT-239R2, where a taxpayer is required to honour a guarantee of a corporation's debt, the taxpayer is considered to have acquired a debt at the time the guarantee is honoured equal to the amount paid under the guarantee. It is a question of fact as to whether this debt represents a bad debt to which subsection 50(1) of the Act applies. Subsection 50(1) of the Act provides for a deemed disposition of the debt at the end of the taxation year for proceeds equal to nil and a reacquisition immediately thereafter at a cost equal to nil. As noted in paragraph 1 of Interpretation Bulletin IT-159R3, any subsequent recovery of the bad debt will be treated as a capital gain.

In this case, the Taxpayer, as the collateral assignee, became entitled to receive the life insurance proceeds on the death of the life insured in XXXXXXXXXX. Since the Taxpayer died in XXXXXXXXXX, the proceeds were received by the Taxpayer's estate in XXXXXXXXXX. If the Taxpayer had received the proceeds, the amount received would have been considered a recovery of a bad debt and included in computing the Taxpayer's income as a capital gain. However, pursuant to paragraph 70(5)(a) of the Act, a deceased taxpayer is deemed to have disposed of each capital property owned immediately before death and to have received proceeds equal to the fair market value of the property immediately before death. Therefore, it is our view that the Taxpayer would have been deemed to have disposed of the capital debt for proceeds equal to the debt's fair market value. Given the facts of this situation, it would not be unreasonable to consider the fair market value of the debt immediately before the Taxpayer's death to be an amount not less than the life insurance proceeds payable under the policy. Assuming that the fair market value of the debt was $XXXXXXXXXX, the result would be a capital gain of $XXXXXXXXXX included in computing the Taxpayer's income on his terminal return. Pursuant to paragraph 70(5)(b) of the Act, the Taxpayer's estate is deemed to have acquired the debt at a cost of $XXXXXXXXXX. Consistent with the above, the life insurance proceeds received by the estate would be regarded as the recovery of a bad debt and therefore as proceeds on the disposition of the debt. Since the amount of the proceeds is the same as the debt's adjusted cost base, the capital gain to the estate is nil.

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 these comments are of assistance.

F. Lee Workman
Manager
Financial Institutions Section
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch