This translation was prepared by Tax Interpretations Inc. The CRA did not issue this document in the language in which it now appears, and is not responsible for any errors in its translation that might impact a reader’s understanding of it or the position(s) taken therein. See also the general Disclaimer below.
Principal Issues: 1) For the purpose of "distribution" as defined under subsection 55(1), in which of the three types of property should a life insurance policy be classified? 2) Whether it would be possible to use liabilities of the distributing corporation to "balance" the assets transferred? 3) Whether it would be possible for the distributing corporation to incur a debt in order to "balance" the assets transferred? 4) Whether the grandfathering provisions set out in paragraph 131(11)(b) of S.C. 1998, c. 19 would still be met after the butterfly reorganisation? 5) Would a split-up of the property of a corporation between siblings always require a pro-rata distribution of each type of property owned by the corporation?
Position: 1) Question of fact. The CRA has shown some flexibility with respect to the classification of assets, the primary aim being to ensure that a particular shareholder is not effectively being "cashed out" in the process. In the past, the CRA has generally considered the cash surrender value (CSV) of an insurance policy as being "cash or near cash" property. The CRA has recently accepted in a ruling to classify the excess of the fair market value of a life insurance policy over its CSV as "investment property". However, in other circumstances, another classification could also be appropriate. 2) The CRA generally accepts that each type of property may be determined on a net basis; however, liabilities must be allocated following a predetermined pattern. 3) No. This would result in a acquisition of cash by the distributing corporation described in paragraph 55(3.1)(a). 4) Possibly, but no definitive conclusion. Question of fact. 5) General comments provided with respect to subsection 55(2), paragraphs 55(3)(a) and (b) and subsection 55(4).
Reasons: 1) Wording of the Act and previous positions.
Financial Strategies and Financial Instruments Roundtable, 7 October 2011
2011 APFF Conference
Question 3 - Life insurance, grandfathering, butterfly
Assume the following situation where a parent had set up a family holding corporation ("FH Inc.") for the parent’s two children, in equal shares, in the context of a freeze effected prior to April 27, 1995. The parent retained control and preferred freeze shares of FH Inc. Upon the death of the parent, all of the parent’s shares were redeemed and cancelled.
Today, the two children ("Child A" and "Child B"), the sole owners of FH Inc.'s common stock, wish to separate their property as part of a butterfly transaction.
FH Inc. holds cash, investments and two life insurance policies taken out before April 26, 1995 on the children's lives (one policy per child) specifically to redeem the shareholding of a child who dies. The policies have a different cash surrender values. A shareholders agreement, signed after April 26, 1995, provides for the purchase for cancellation by the corporation of the deceased child's shares out of the capital dividend account created by the receipt of the proceeds of the policy taken on the life of that child.
The shares held by the children are thus grandfathered.
Step 1: Child A transfers, on a tax-deferred basis under section 85, his shares of the capital stock of FH Inc. to a newly incorporated holding corporation ("A Inc.") in exchange for shares of the capital stock of A Inc. Child B transfers, also on a tax-deferred basis, her shares of the capital stock of FH Inc. to a new corporation ("B Inc.") in exchange for shares of the capital stock of B. Inc.
Second step: FH Inc. makes the following transfers, also on a tax-deferred basis by virtue of section 85:
- the transfer to A Inc. of half of its cash and investments, as well as the life insurance policy taken on the life of Child A (so that A Inc. receives its pro-rata share of each type of property of FH Inc.);
- the transfer to B Inc. of half of its cash and investments, as well as the life insurance policy taken on the life of Child B (so that B Inc. receives its pro-rata share of each type of property of FH Inc.);
Third step: A Inc. and B Inc. each redeem the shares of their capital stock that were issued to FH Inc. in the second step. Each of them issues a note to FH Inc. in settlement of the redemption price.
Fourth step: FH Inc. is wound up and, as part of the winding-up, the notes issued by A Inc. and B Inc. in the third step are respectively assigned to them. As a result, the obligations under the notes are extinguished. Finally, FH Inc. is dissolved.
Questions to the CRA
1. Given the need for a proportional division of the corporation's assets between its shareholders, will there be proportional division of insurance policies in the following situations, where the policies have a different cash surrender value ("CSV") or fair market value ("FMV")?
1.1. Setting-off the liquid assets of FH Inc. For that purpose, in which class of property is a life insurance policy assigned: cash and cash equivalents; or investment property? Although we exclude "business property" in this case because there is a holding company, could an insurance policy, in other circumstances, fall into "business property"?
1.2. By using the debt of FH Inc. (if any) to effect the equalization.
1.3. By borrowing on a policy so that its net worth equals that of the other.
2. Once transferred to their respective corporations, will the insurance policy taken on the life of each child allow it to continue to benefit from grandfathering?
3. If this transaction for the sharing of property between the children, through A Inc. and B Inc., were effected during the lifetime of the parent (controlling FH Inc.), would it have been necessary to deal with the proportionality test in the division of the property?
CRA Response to Question 1.1:
The Act does not define the concept of types of property in the definition of "distribution" in subsection 55(1). However, in accordance with the administrative position established by the CRA for the classification of property for the purposes of the proportional distribution of each type of property, there are three categories of types of property, i.e. "cash or cash equivalents”, “investments” and “business property”.
The purpose of classifying the property of a distributing corporation into these three classes is to assure, in the context of a distribution, a proportionate distribution to each transferee corporation, based on the transferee corporation's interest in the distributing corporation, of a share of each type of property owned by the distributing corporation. The tax policy underlying that objective is to prevent one of the transferee corporations from cashing in or selling its stake in the distributing corporation on a tax-free basis (i.e., no cash-out).
From that perspective, each situation calls for a case-by-case examination. In general, the CRA demonstrates some flexibility in the classification of property, with the objective of adhering to the underlying tax policy set out above. Thus, the best way to ascertain the classification of the assets of a distributing corporation during a butterfly transaction is to submit an advance ruling request to the Income Tax Rulings Directorate.
That said, the classification of a life insurance policy will depend on several factors. Although it is not an exhaustive list of elements to be considered, it is possible to point out that criteria such as the possibility or intention to monetize the policy, the state of health of the insured person, whether or not the insurance policy has a cash surrender value (CSV), as well as the nature of the other property held by the distributing corporation will be examined to determine in which class of property the FMV of a life insurance policy should be classified. Consequently, the analysis as to the classification of a life insurance policy should be done on a case-by-case basis.
In advance rulings issued in the past, the CRA generally included the CSV of a life insurance policy in "cash or cash equivalents".
Recently, in advance ruling 2010-0358061R3, the CRA also had to determine which type of asset class to include the excess of the FMV of a life insurance policy over its CSV. In the circumstances of that specific case, the CRA agreed to classify the CSV of life insurance policies as "cash or cash equivalents," while the excess of life insurance policies' FMV over their CSV was classified as "investment property". In 2010-0358061R3, the distributing corporation did not own any business property. In other circumstances, it may be possible for the excess of the FMV of an insurance policy over its CSV to be included in the "business property" class. It should also be noted that if the circumstances of a case show an intention to cash out the life insurance policy or if the death of the insured person is imminent, the FMV of a life insurance policy, including its CSV, as the case may be, may need to be classified as "cash or cash equivalents". In closing, it should be remembered that the classification of a property as part of a butterfly transaction always requires an examination of all the facts and circumstances relating to a particular situation. It is therefore possible that a different classification of a life insurance policy may be justified in a particular context.
CRA Response to Question 1.2:
The Act technically provides for the division of the FMV of each type of property of the distributing corporation on a gross basis. However, by administrative position, the CRA allows asset distributions to be made using the net FMV, that is, after deducting liabilities for the types of property distributed. However, that administrative relief is limited, and the liabilities must be allocated in a predetermined manner. Thus, the general position of the CRA is that:
a) Short-term debt must be allocated and applied to reduce the FMV of each property forming part of cash or near-cash assets (before the reclassification of certain types of cash or near cash assets (for example, accounts receivable, inventories and prepaid expenses) as business assets as generally permitted by the CRA under certain conditions) in proportion to the FMV of each element of cash or near cash assets to the total FMV of all cash or near cash assets. The allocation of short-term debt must not exceed the total FMV of all cash or near cash assets. The short-term debts that will be allocated to property that will initially be cash or near cash and that will be reclassified as business property if applicable, must be considered thereafter as debts allocated to business property.
b) Debts, other than short-term debts, that relate to specific assets, must be allocated to them to the extent of their FMV. The entire portion of such debt in excess of the FMV of a property must be considered in relation to the type of property to which the particular property relates (and not to a particular property).
c) Debts, other than short-term debts, that do not relate to specific assets but relate to a specific type of property, must be allocated to the type of property to which they relate, up to the FMV of that type of property, determined after the allocation provided for in paragraph (b) above.
d) If applicable, all remaining debts, after the allocations referred to in paragraphs a) to c) above, must be allocated and applied to reduce the FMV of each type of property in proportion to the FMV of each type of property, such FMVs being determined after the allocations referred to in paragraphs a) to c) above and up to the FMV of that type of property determined after the allocations referred to in paragraphs a) to c) above.
That said, it may not be possible to fully equalize the proportions of each type of distributed property to be allocated to the transferee corporations even using the net FMV method accepted by the CRA. In such a case, a possible solution could be the proportional transfer by the distributing corporation to the transferee corporations of undivided rights in assets which are difficult to partition. For example, in advance ruling 2010-0358061R3, the distributing corporation transferred to the four transferee corporations an undivided 25% interest in three life insurance policies.
CRA Response to Question 1.3:
Paragraph 55(3.1)(a) excludes the application of paragraph 55(3)(b) in particular in circumstances where a property becomes the property of the distributing corporation, other than as a result of a transaction expressly permitted in subparagraphs 55(3.1)(a)(i) to (iv), in contemplation of a distribution in the course of the reorganization in which the dividend was received and before such distribution.
In general, the CRA considers that a loan made by a corporation technically results in an acquisition of cash by the corporation. Thus, in the particular situation described above, the CRA may consider that the acquisition of cash by the distributing corporation as a result of the loan would come within paragraph 55(3.1)(a) and would have the effect of subjecting intercorporate dividends to the application of subsection 55(2).
CRA Response to Question 2:
Subsection 112(3) is a "stop loss rule", which may have the effect of reducing the loss resulting from the disposition of a share held as capital property by a taxpayer, other than a trust, by the amount of the non-taxable dividends received on that share. In the context of the legislative amendments to subsection 112(3), which, among other things, had the effect of subjecting individuals, other than a trust, to the stop loss rules with respect to the dispositions of shares made after April 26, 1995, several transitional rules were also introduced to protect acquired rights (the "grandfathering rules").
In light of the facts described in the particular situation, we understand that the exception provided for in paragraph 131(11)(a) of S.C. 1998, c.19 of the transitional rules would not apply.
The transitional rule introduced in the Act by subsection 131(12) of S.C. 1998, c.19 sets out among other things that, for the purposes of the exception provided for in paragraph 131(11)(b) of S.C. 1998, c. 19, which excludes the application of subsection 112(3) to certain provisions, a share of the capital stock of a corporation that was acquired in exchange for another share in a transaction contemplated by sections 51, 85, 86 or 87 is deemed to be the same share as the old share.
The exception in paragraph 131(11)(b) of S.C. 1998, c. 19, is for the disposition of a share of the capital stock of a corporation (in this case, a share of the capital stock of A Inc. or B Inc.) made to the latter, where the following conditions are satisfied:
(i) On April 26, 1995, the share (in this case, of the capital stock of FH Inc. (old share), with the share of the capital stock of A Inc. or B Inc. being deemed to constitute the same share as the old share under subsection 131(12) of S.C. 1998, c. 19) was owned by an individual (Child A or Child B),
(ii) On April 26, 1995, a corporation (FH Inc.) was the beneficiary of a life insurance policy on the individual (Child A or Child B),
(iii) On April 26, 1995, it was reasonable to conclude that one of the principal purposes of the life insurance policy was to fund, directly or indirectly, in whole or in part, the redemption, acquisition or cancellation of the share by the corporation that issued the share (FH Inc.).
(iv) the disposition was made by a person described in clauses 131(11)(b)(iv)(A) to (D) of S.C. 1998, c. 19 (for example, the individual (Child A or Child B) or the individual’s spouse or common-law partner, the estate of the individual or of the individual’s spouse or common-law partner during the first taxation year of the estate, etc.).
The CRA has reiterated on a number of occasions that grandfathering eligibility survives a shareholder's transfer, pursuant to subsection 85(1), of the shareholder’s shares of the capital stock of a corporation holding a life insurance policy to the shareholder’s holding corporation. In addition, as indicated in Income Tax Technical News No. 12 of February 11, 1998 (archived), any changes, modifications or terminations made to the life insurance policy after April 26, 1995 should not in itself cause the benefit of the grandfathering rules to be lost. For example, it was decided that a subsequent change in the ownership and the beneficiary of a life insurance policy, subject however to other considerations, should not affect the survival of the grandfathering rules (see in this regard Technical Interpretation No. 9916175 and Documents No. 2010-0359431C6 and 2011-0398401C6).
It is possible that a future disposition of the shares of the capital stock of A Inc. and B Inc. may satisfy the conditions set out in paragraph 131(11 (b) of S.C. 1998, c.19. However, it is impossible for us to make a final determination on that point in the circumstances, since the application of the transitional rule in paragraph 131(11)(b) of S.C. 1998, c. 19 and the circumstances surrounding each particular situation (among other things, ensuring that the purpose test provided for in subparagraph 131(11)(b)(iii) of S.C. 1998, c. 19 is satisfied, to determine whether the disposition of the capital stock of A Inc. or B Inc. is performed by a person prescribed in clauses 131(11)(b)(iv)(A) to (D) of S.C. 1998, c. 19, etc.).
CRA Response to Question 3:
In general, inter-company asset-sharing transactions may result in dividends that may be subject to the application of subsection 55(2). However, subsection 55(3) provides exceptions that permit not being subject to the application of subsection 55(2) to dividends so received. Paragraph 55(3)(b) applies to dividends received in the course of certain corporate reorganizations, commonly known as butterfly reorganizations. Paragraph 55(3)(a) covers, for its part, a dividend received in respect of certain transactions between related parties, provided that at any time none of the facts set out in subparagraphs 55(3)(a)(i) to (v) applied as part of a transaction, event or series of transactions or events in which the dividend was received.
As previously discussed, a butterfly reorganization allows a proportional, tax-deferred distribution of the distributing corporation’s assets among its shareholder corporations. However, such a reorganization requires, among other things, a distribution of the proportionate share of each type of property of the distributing corporation to the transferee corporations. The exception in subparagraph 55(3)(a) does not require such a proportional distribution of property. However, as noted above, the series of transactions as part of which the dividend was received must not include any distributions or increases in ownership referred to in any of subparagraphs 55(3)(a)(i) to (v), that is, distributions or increases in holdings of persons unrelated to the dividend recipient.
With that in mind, subparagraph 55(5)(e)(i) sets out that, for the purposes of section 55, a person shall be deemed to be dealing with another person at arm’s length and not to be related to the other person if the person is the brother or sister of the other person. Subparagraph 55(5)(e)(iv) emphasizes further that paragraph 251(3) should not be taken into account for the purposes of section 55.
In the past, the CRA has already agreed, in certain limited circumstances, to exclude the application of subsection 55(2) because of the exception in paragraph 55(3)(a) to dividends resulting from the division of property between corporations whose shareholdings included brothers and sisters insofar as the presence of their parents in the shareholding of the corporations involved made it possible to comply with the conditions set out in paragraph 55(3)(a). Thus, depending on the facts and the structure of the projected transactions when sharing property between children, such sharing could be considered in the context of certain reorganizations of family businesses.
Furthermore, subsection 55(4) could apply to deem persons not to be related to each other where it can reasonably be considered that one of the main purposes of transactions or events was to cause persons to be related to each other or to cause a corporation to control another corporation, so that subsection 55(2) would not apply to dividends. The application of subsection 55(4) requires an examination of all the facts and circumstances surrounding a particular situation. For example, and in a very general way, the CRA has already taken the position that subsection 55(4) should not apply where the primary reason for a shareholder to hold a sufficient number of shares of the capital stock of a corporation to control it was to protect its economic interests.
October 7, 2011
All rights reserved. Permission is granted to electronically copy and to print in hard copy for internal use only. No part of this information may be reproduced, modified, transmitted or redistributed in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, or stored in a retrieval system for any purpose other than noted above (including sales), without prior written permission of Canada Revenue Agency, Ottawa, Ontario K1A 0L5
© Her Majesty the Queen in Right of Canada, 2011
Tous droits réservés. Il est permis de copier sous forme électronique ou d'imprimer pour un usage interne seulement. Toutefois, il est interdit de reproduire, de modifier, de transmettre ou de redistributer de l'information, sous quelque forme ou par quelque moyen que ce soit, de facon électronique, méchanique, photocopies ou autre, ou par stockage dans des systèmes d'extraction ou pour tout usage autre que ceux susmentionnés (incluant pour fin commerciale), sans l'autorisation écrite préalable de l'Agence du revenu du Canada, Ottawa, Ontario K1A 0L5.
© Sa Majesté la Reine du Chef du Canada, 2011