10 May 1996 Income Tax Severed Letter 7M12851 - LIFE INSURANCE 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 Department.

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

Principal Issues:

Discussing various transactions involving universal life insurance policies

Position: See attached

Reasons:See attached

CALU MAY 1996

In preparing for this conference, Mr. Strain provided me with several examples or scenarios and asked me to comment on whether or not the Department would have either technical concerns, or would consider applying the anti-avoidance rules in the Act - most notably the general anti-avoidance rule, or GAAR. From this input, I have examined the various steps involved and will comment on what might be of concern to the parties in the transactions. By doing this I hope you will then have an understanding of Revenue Canada's general views as they relate to the day-to-day transactions you are involved in.

First of all, many transactions involve the acquisition of universal life policies, and the many options that can be present in this type of policy. Often, the main concern is whether or not the policy is an "exempt" policy such that the accrual rules do not apply.

To determine whether a particular life insurance policy (including a universal life insurance policy) is an "exempt policy" for purposes of the Income Tax Act, the definition found in section 306 of the Income Tax Regulations must be considered. The purpose of this test is to distinguish between policies that mainly provide insurance protection and those that mainly provide savings with only ancillary insurance protection.

This is an ongoing test and continual monitoring is required. The insurance companies are in a position to provide such a monitoring and to inform the policyholders as to the status of their policies.

As was stated in a 1993 article presented by Mr. Strain to the Canadian Tax Foundation:

"A policy holder is not in a position to monitor the exempt status of a policy. The annual test can be applied only by the insurance company with information not generally available to the policy holder. Consequently, contractual guarantees will be particularly important to the policy holder to ensure that exempt status is maintained."

Thus, the on-going tests are provided for in the law, and it is up to the parties to ensure they do not go off-side. Obviously advance rulings cannot be given on this issue, since the result depends on future events.

Some transactions may involve the disposing of taxable income-earning assets, such as marketable securities and the replacement of these assets with different types of life insurance policies. Such a decision should not be a cause of concern in and of itself for purposes of the Income Tax Act.

While there are tax benefits associated with the ownership of different assets, the anti-avoidance rules are not intended to force a taxpayer to buy or hold on to assets that generate the maximum amount of income for tax purposes.

Other transactions involve the use of borrowed money to buy assets, and naturally the concern is whether or not the interest in deductible. One issue relates to the situation where borrowed money was used to purchase marketable securities which generate taxable income and then some or all of these are sold and the funds used to purchase a life insurance policy.

Is the interest on the loan still deductible? In order to answer that question we have to consider 4 situations, 2 are where all of the securities are sold and the proceeds are used to purchase the policy, and 2 are where only a portion of the securities are sold and the proceeds are used to purchase a policy.

1.If all of the securities are sold for proceeds equal to or greater than original cost, all of the loan will be considered to be used to acquire the policy and the interest will no longer be deductible.

2.If only some of the securities are sold for proceeds equal to or greater than original cost, interest on the borrowed money will continue to be deductible to the extent that the borrowing is reflected in the cost of the remaining securities. For example, if one half of the securities having the same cost are sold and the proceeds used to pay premiums, interest on one-half of the original loan would continue to be deductible.

3.If all of the securities are sold for proceeds less than original cost and the proceeds are used to pay premium deposits, as before, all of the loan would, except for the application of section 20.1, be considered to be used to acquire the policy. However section 20.1 provides relief in that a portion of the original loan equal to the loss on the disposition of the securities will be deemed to be used for an income earning purpose, and the interest on that amount will continue to be deductible. For example, assume that a $1000 loan is still outstanding on shares that cost $1000 but were sold for $750, which proceeds were then used for non-income producing purposes. In effect, section 20.1 provides that a $250 portion of the loan outstanding equal to the loss amount is deemed to be used by the taxpayer for the purpose of earning income from the property.

4.If a portion of the securities are sold for proceeds less than original cost, as before, the interest on the loan used to acquire the securities will continue to be deductible to the extent that the loan is reflected in the cost of the remaining securities. Furthermore, as in the third case above, section 20.1 provides that the portion of the original loan equal to the loss on the disposition will be deemed to be used for an income producing purpose, and the interest on the amount will continue to be deductible. For example, assume a $1000 loan is outstanding on shares that cost $1000 but now have a fair market value of $500. If one half the shares are sold for proceeds of $250, which proceeds are then used for non-income producing purposes, interest on the portion of the original loan which is related to the cost of the remaining shares ($500) will continue to be deductible, and section 20.1 deems that interest on the loan equal to the amount of the loss on the disposition ($250) will also continue to be deductible.

There are some transactions which are designed to convert non-deductible interest into deductible interest. Consider, for example, the situation where a company owns marketable securities, decides to sell them and use the funds to buy a life insurance policy. The company then borrows money and purchases new marketable securities, claiming the borrowed money has now been used for the purpose of earning income.

This situation is very similar to that of the case of Zwaig 74 DTC 1121, except that Mr. Zwaig borrowed on the policy itself to purchase the new securities. The Tax Review Board disallowed the interest deduction since it considered the substance of the use of the borrowed funds to be the purchase of a life insurance policy and not the acquisition of securities. In The Queen v Bronfman 87 DTC 5059 the Supreme Court cited this case with approval.

The difficulty then is where to draw the line between independent decisions taken by a taxpayer to sell one asset and later buy another, and those transactions where the steps are linked such that they should be recharacterized using the GAAR. Well, there are no guidelines nor can any arbitrary time period be imposed. I would hope that where the steps are truly independent and thus not part of a series of transactions, this should be obvious, and that where the transactions were only designed to change the appearance of the use of the borrowed money, this too would be obvious. I do concede, however, that there will be grey areas of concern to both your clients and my Department.

Another case involves what might be called upstream transactions where a subsidiary company borrows money and pays a dividend to its parent company, who then uses the funds to buy a life insurance policy.

We have not seen this type of transaction in the form of a ruling or audit referral. Where a corporation borrows money to pay a dividend the interest on that borrowing will be deductible under 20(1)(c) provided the dividend does not exceed its accumulated profits (defined). A shareholder who receives a dividend is not normally restricted in how those amounts can be used.

In the situation described if the insurance policy in question can be linked to the borrowing, for example where it is used as collateral for the loan by the related corporation, then perhaps there may be argument that the GAAR could apply to the series of transactions such that they would be recharacterized to deny the interest deduction on the basis that the substance of the transactions was to borrow money to buy a life insurance policy.

Then there is what might be called the downstream transactions where a shareholder borrows money to invest in common shares of a company, which in turn uses the funds to buy a life insurance policy on the life of the shareholder.

The analysis in this case turns more on the paragraph 20(1)(c) deduction rather than whether or not this is an avoidance transaction. Such an analysis was made by the Tax Court in Mark Resources Inc. v The Queen 93 DTC 1004, where the Court looked to the real purpose of the use of the borrowed funds. Applying the same logic to this situation, our position is that the real purpose is to buy a life insurance policy, and thus the requirements for interest deductibility are not met. There is no extra income for tax purposes generated by the borrowed money.

Another type of transaction that we understand has been considered is where one company in a corporate group purchases a life insurance policy on the life of its shareholder, but designates another company as the beneficiary of the policy. The advantage of doing so is that the full amount of the proceeds on death will go into the capital dividend account, as opposed to the proceeds less the adjusted cost base of the policy.

The capital dividend account definition in section 89 of the Income Tax Act includes in paragraph (d) of that definition the proceeds of a life insurance policy which are received by the corporation in excess of the adjusted cost basis of the policy to the corporation. It is clearly the intent of the legislation that the insurance proceeds be reduced by the adjusted cost basis of the policy although this would not be the result where the corporation is not the policyholder. We have brought this to the attention of the Department of Finance for their consideration.

As well, although our auditors have not yet raised this issue, it may very well be that there is a reasonable argument for applying the GAAR.

Another example submitted to us involved the use of an annuity contract which payments in turn fund the premiums for a life insurance policy. The transaction is structured in this manner since most likely it is not possible to buy an exempt policy with one or two up-front payments. Thus, here, the up-front payment is used to buy an annuity contract which then funds annual premium payments, and the exempt policy tests can be met.

As well, it is possible that by combining the products the impact of subsection 70(5.3) can be avoided. Subsection 70(5.3) provides that in determining the fair market value of the shares held by a taxpayer in a corporation immediately before his/her death, the fair market value of any life insurance policy under which the taxpayer was the person whose life was insured is the cash surrender value of the policy at that time.

It is also possible to incorporate a loan into the series of transactions, which loan is only repayable out of the death benefits of the policy. The loan, of course, will reduce the value for income tax purposes of the shares of the borrower immediately before death.

In all cases where back-to-back financial products are issued, we will consider whether or not the products would have been issued on a stand-alone basis. For example, we would consider whether or not the annuity contract and the life insurance policy if issued by themselves would contain the same terms and conditions. We would look at the premiums, cash surrender values, cash values, investment income earned within the contract, annuity payments, termination rights, etc. With a loan added to the steps we would look at the interest rates, repayment terms, collateral provided, etc.

If we were to determine that such contracts would not be issued on a stand-alone basis, or that the series of transactions results in a misuse of the provisions of the Income Tax Act we would certainly consider applying the GAAR to recharacterize the transactions in order to deny the inappropriate tax benefits.

Mr. Strain asked that we address a concern of yours that arises from a recent technical interpretation where we said that we are currently reviewing the potential application of paragraph 56(1)(d) of the Act to periodic disability payments. We have suggested that because of the very broad definition of "annuity" under the Act it is arguable that the payment of income replacement benefits under a disability insurance policy could be required to be included in income. This would represent a reversal of Revenue Canada's position.

We have not reversed the Department's stated position that these payments are not taxable. The correspondence referred to above arose out of our review of other situations involving periodic payments and the broad definition of "annuity" in the Act. This review has indeed raised the concern referred to, and we will be consulting with the Department of Finance to further consider this matter. I would assume that if there were to be any changes to our public positions relating to this issue, they would only be prospective in nature.

Finally, we were asked to discuss guidelines that could be applied to determine if a wage loss replacement plan is considered to have been established for the benefit of an individual in the capacity as a shareholder rather than in the capacity as an employee. This is important since the tax consequences of both the payment of premiums by the corporation and the receipt of benefits by the member are dramatically different depending on whether or not the insured is an employee or shareholder.

The Department has always maintained that the determination of whether a benefit is received by an employee-shareholder in his or her capacity as an employee or as a shareholder involves a finding of fact. Furthermore, the Department has always started with the presumption that an employee-shareholder receives a benefit by virtue of his or her shareholdings, where the shareholder or shareholders can significantly influence business policy. When the benefit is being derived by participation in a group plan, such as a wage loss replacement plan, and each member of the group is a shareholder as well as an employee, the same concern has to be dealt with.

In examining any particular case, the following factors would be relevant:

(i) Is participation in the plan made available to all employees unless there is a logical reason to exclude some employees?

(ii)Are the benefits available under the plan are the same for all employees both in their nature and quantum?

(iii)When all the participating employees are also shareholders, is the benefit coverage similar to coverage given to non-shareholder employee groups for similar size businesses who perform similar services and have similar responsibilities.

These criteria are necessarily phrased in broad terms because the particular circumstances of a specific situation must be taken into account.

The Department has made its general views on this subject known on a number of occasions over the years so that the position outlined herein should not be considered as a recent clarification. On the next revision to interpretation bulletin IT-428 "Wage Loss Replacement Plans," consideration will be given to including some additional comment on the shareholder versus employer aspect.