28 May 1997 CALU Roundtable Q. 1, 9708810 - GRANDFATHERING PROVISIONS RELATED TO 112(3) TO (3.32)

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:

Grandfathering provisions related to subsections 112(3) to (3.32) and various issues concerning life insurance policies dealt with at the May 1997 CALU Conference.

Position:

See questions and answers.

Reasons:

See questions and answers.

CALU MAY 1997
CONFERENCE FOR ADVANCED LIFE UNDERWRITING

QUESTION 1

If an agreement in writing made before April 27, 1995 is modified or amended in whole or in part after that date, will a subsequent disposition of shares that occurs pursuant to the modified agreement qualify for the transitional relief under Clause 57(10)(a)?

RESPONSE

It is our view that the grandfathering provisions provided for under the proposed Clause 57(10)(a) will continue to apply as long as the agreement in writing made before April 27, 1995 is not altered or modified in any way.

QUESTION 2

An agreement in writing made before April 27, 1995 stipulates that a shareholder may sell or transfer shares to a third person only where the third person consents to be bound by the agreement. Will the transitional relief under Clause 57(10)(a) apply to the disposition by the shareholder to the third person and will it also apply to a subsequent disposition of the shares by this third person?

RESPONSE

Where the disposition by the shareholder to the third person is contemplated in the agreement in writing made before April 27, 1995 such that the third person can be identified in this agreement then we are of the view that the transitional relief under Clause 57(10)(a) will apply to the disposition by the shareholder to the third person. However, the transitional relief under Clause 57(10)(a) will not apply to the subsequent disposition by the third person since it would be made by a person who was not a party to the agreement in writing made before April 27, 1995.

QUESTION 3

Subsection 146(4) of the Canada Business Corporations Act provides that a transferee of shares subject to a unanimous shareholder agreement is deemed to be a party to the unanimous agreement. Will the transitional relief under Clause 57(10)(a) apply with respect to a disposition by a transferee of shares acquired after April 26, 1995 where such shares were subject to a unanimous shareholder agreement entered into on or before that date?

RESPONSE

A unanimous shareholder agreement, pursuant to subsection 146(2) of the Canada Business Corporations Act, is a written agreement among the shareholders that restricts the powers of the directors to manage the business and affairs of the corporation. Subsection 146(4) applies only for purposes of section 146 including subsection 146(2) which deals with the powers of the directors and not the disposition of shares. Accordingly while the subsequent shareholder will be considered a party to the unanimous shareholder agreement this in itself would not in our view be sufficient basis to conclude that the subsequent disposition of the shares was pursuant to an agreement in writing made before April 27, 1995.

QUESTION 4

Will the transitional relief under Clause 57(10)(a) apply to a disposition of shares by a shareholder to a third party as a consequence of the exercise by the shareholder of a "put" option provided for in an agreement in writing made before April 27, 1995; or as a consequence of the exercise by a third party of a "call" option provided for in such an agreement?

RESPONSE

Where an agreement in writing made before April 27, 1995 specifically provides for and contemplates these "put" and/or "call" options and such options are later exercised it is our view that the disposition would be pursuant to the agreement in writing made before April 27, 1995. The third party would also have to be identified in this agreement.

QUESTION 5

The parties to an agreement in writing made before April 27, 1995 may choose to revise the terms of their relationship not by amending their existing agreement that was made before April 27, 1995 but by concluding a separate agreement dealing with the new arrangements. Would a subsequent disposition of the shares be pursuant to the agreement in writing made before April 27, 1995?

RESPONSE

Where a separate agreement is entered into by the parties to an agreement entered into before April 27, 1995 to revise the terms of their relationship the grandfathering of the agreement made before April 27, 1995 will be lost if the separate agreement is considered to cancel, nullify or replace the agreement made before April 27, 1995.

QUESTION 6

A letter dated February 12, 1997 from Len Farber of the Department of Finance to Bill Strain has proposed further amendments to the grandfather relief pursuant to Clause 57(10)(b) such that the grandfathering may apply "provided that a main purpose of the life insurance policy was to fund a redemption. The life insurance requirement will also be amended to clarify that the proceeds of the policy were to be used for the purpose of a redemption, acquisition or cancellation of the shares by the issuing company." What are some general guidelines as to the criteria that may be used in making the determination of a main purpose of the life insurance policy?

RESPONSE

We will preface our response to this question and others that follow by saying that our policy is to provide interpretations of the provisions of the Income Tax Act or draft legislation. Accordingly we can only provide you with general comments with respect to the proposals set forth in the letter from Mr. Farber referred to above.

The determination of a main purpose or the purposes for the acquisition of a life insurance policy can only be made based on the evaluation of the facts and circumstances of each particular case. As a result it is not possible for us to provide you with any general guidelines or checklist as to what criteria may be used to make such a determination.

QUESTION 7

Where a life insurance policy was intended to provide both key person coverage to indemnify the corporation against financial loss caused by the death of a key shareholder and funding to redeem the shareholder's shares in the event of death, was a main purpose of the life insurance policy to fund a redemption of shares?

Where a life insurance policy was intended to provide funding for a shareholders' agreement pursuant to which there was an option for the surviving shareholder to purchase the shares from the estate of the deceased shareholder and to fund this purchase by a dividend it would receive from the corporation; or for the corporation to redeem the shares, was a main purpose of the life insurance policy to fund a redemption of shares?

RESPONSE

It is our view that where the legislator refers to "a" main purpose as opposed to "the" main purpose it would be possible to have more than one main purpose with respect to the life insurance policy.

It is also our view that where an agreement provides for an option as described above, the option would not preclude the existence of a main purpose with respect to the life insurance policy.

QUESTION 8

What documentary evidence will Revenue Canada ordinarily require to substantiate a claim for grandfathering relief such as establishing that a main purpose of a life insurance policy acquired by a corporation was to fund a redemption of shares by the corporation?

RESPONSE

In this regard the policyholder must be able to provide documentary evidence to substantiate that grandfathering applies with respect to a particular situation. While we are not in a position to provide an exhaustive list of the documentation that existed prior to April 27, 1995 to substantiate a main purpose for acquiring a life insurance policy we would expect that documents issued by the insurance corporation, minutes of the corporation, correspondence from the legal advisors or the accountants or any correspondence relating to the issuance of such a life insurance policy would all be relevant documents in making such a determination.

QUESTION 9

To qualify for transitional relief under Clause 57(10)(b), a taxpayer must demonstrate that certain conditions related to a life insurance policy existed on April 26, 1995. Will Revenue Canada confirm that any changes to the life insurance policy made after April 26, 1995 will not result in the loss of grandfathered status?

RESPONSE

It is our view that any further modifications or alterations or cancellation of such a policy should not have any consequences in terms of the grandfathering provisions as they read in the first reading of Bill C-69 which was tabled on December 2, 1996 provided the requirements set out in the grandfathering provisions under Clause 57(10)(b) relating to the life insurance policy existed on April 26, 1995.

QUESTION 10

The insurer frequently provides "temporary coverage" between the date on which the insured makes an application for a life insurance policy and the date on which the life insurance policy is finally issued. Where a corporation was the beneficiary of such "temporary coverage" in these circumstances will Revenue Canada confirm that the corporation will be considered to have been a beneficiary of a life insurance policy within the meaning of Clause 57(10)(b)?

RESPONSE

Whether or not a beneficiary of "temporary coverage" would be considered a beneficiary of a life insurance policy within the meaning of Clause 57(10)(b) is a question of fact which can only be determined by the issuer of such a "temporary coverage" since this is a legal question which may also involve the review of the relevant provincial statutes.

You have advised that under the Insurance Act of Ontario a life insurance policy can only take effect after it has been delivered by the life insurer. In this regard, to meet the requirements of this provision in a situation described in your question life insurance policies referred to as "conditional insurance agreements" have been issued by life insurers. It is our understanding that a "conditional insurance agreement" is a separate life insurance policy issued before the main life insurance policy will be issued and that it will normally be issued for a substantially reduced amount of insurance coverage. It appears to us that if such an agreement is a life insurance policy for purposes of the Insurance Act of Ontario then it would also be a life insurance policy for purposes of Clause 57(10)(b). It would then be a factual determination as to whether or not this life insurance policy otherwise meets the requirements set out in Clause 57(10)(b).

Where "temporary coverage" may refer to something other than a "conditional insurance agreement" it would seem that the key determination to be made is whether the "temporary coverage" is evidence of a policy being issued prior to April 27, 1995.

QUESTION 11

A shareholder may receive more than one class of shares in exchange for shares of a single class. Will Revenue Canada confirm that the provisions of Clause 57(11) apply to all of the shares received in such transactions?

RESPONSE

Clause 57(11) refers to a share acquired in exchange for another share in a transaction to which any of sections 51, 85, 86 or 87 of the Income Tax Act applies. It is our view that the provisions of Clause 57(11) will apply to all shares received by a shareholder even if shares of more than one class are received in exchange for shares of a single class.

QUESTION 12

Where an exempt life insurance policy is distributed to a beneficiary of an RCA on its wind-up and the transfer of the policy meets the conditions of paragraph 254(a) of the Income Tax Act, will the beneficiary be taxable only as amounts are received under the policy? Basically, paragraph 254(a) of the Income Tax Act provides that there is no immediate taxation where a beneficiary of a pension plan receives an annuity to replace his or her rights under the pension plan, and the annuity does not provide any additional rights. In this case, the beneficiary will be taxed on the annuity payments as received. Similarly, where a corporation transfers an exempt life insurance policy that meets the conditions of paragraph 254(a) of the Income Tax Act to an employee in satisfaction of the employee's rights under a non-registered pension plan, will the employee be taxable only as amounts are received under the contract or policy? In both situations, there appears to be a tax policy concern. The employee will not have any immediate tax consequences even though the transfer of the policy, in the first case, will be considered a distribution from an RCA resulting in a refund of Part XI.3 taxes. In the second case, the employer will be entitled to an immediate deduction.

RESPONSE

Where the conditions of paragraph 254(a) of the Income Tax Act are satisfied, the Department has previously ruled and opined that a taxpayer will only be taxed as amounts are received in accordance with the particular document or contract. Even though the results might be seen as being inconsistent with general tax policies underlying other provisions in the Act, paragraph 254(a) of the Income Tax Act clearly provides for the deferral of income by the taxpayer. Consequently, the beneficiary in the first case and the employee in the second case will be taxable only as amounts are received under the contract or policy, as the case may be. However, the determination of whether the conditions of paragraph 254(a) of the Income Tax Act would be satisfied is a question of fact requiring a review of all of the relevant contracts and agreements. In particular, the contract or policy cannot provide the taxpayer with additional rights that are not in the original pension plan.

QUESTION 13

In a recent decision of the United States District Court of the Southern District of New York (Miller v. Heller, 90 CIV. 3763), the Court was asked to consider whether a particular retirement plan was "funded" for purposes of determining whether the plan qualified as a "top hat plan" under the U.S. Employee Retirement Income Security Act. In determining whether funding existed, the Court had to resolve whether or not the beneficiary had a legal right any greater than that of an unsecured creditor to a specific set of funds. Under the provisions of subsection 207.6(2) of the Income Tax Act, an interest in a life insurance policy acquired by an employer will be deemed to be property held by a retirement compensation arrangement where the interest in the policy may reasonably be considered to be acquired to fund an employee's retirement benefits. Will Revenue Canada apply the principles set out in Miller v. Heller in determining whether retirement benefits are funded by a life insurance policy acquired by an employer?

RESPONSE

In our response to QUESTION 30 at the Revenue Canada Round Table at the 1988 Canadian Tax Foundation Conference, we said this provision would apply whenever a life insurance policy is acquired to meet an employer's obligations to pay retiring allowances even though the employer is the owner of the policy and the sole beneficiary. This would also apply where the life insurance policy is acquired to fund any other retirement benefit. We have not changed this position and we will not rely on the principles set out in Miller v. Heller until a Canadian court has established that the Income Tax Act and the particular U.S. legislation involved in Miller v. Heller are worded similarly and the term "fund" is used in the same context.

QUESTION 14

Is Revenue Canada considering making any changes to Interpretation Bulletin IT-430R3 concerning life insurance policies which are pledged as collateral security for money borrowed by a private corporation or a partnership?

RESPONSE

It was not intended that there be a change in the Department's position with regard to situations where a life insurance policy has been assigned as collateral for securing indebtedness, as opposed to an absolute assignment of the policy, and the debtor remains beneficiary under the policy. In such a case as the proceeds of the insurance policy would be constructively received by the debtor/beneficiary, even though paid directly to the creditor in accordance with the assignment, the proceeds in excess of the adjusted cost basis of the policy would be included in the capital dividend account of the debtor. Paragraph 6 of IT-430R3 is currently being changed in this regard.

We would like to add that paragraph 6 of IT-430R2 was changed in IT-430R3 to indicate that a debtor corporation cannot add to its capital dividend account the proceeds of a life insurance policy when the proceeds are received by the lender as beneficiary even if the debtor corporation pays the premiums. This is because the debtor corporation does not receive, as beneficiary, the life insurance proceeds as required by paragraph (d) of the definition of "capital dividend account" in subsection 89(1) of the Income Tax Act. This change is effective for proceeds of a life insurance policy received on or after February 10, 1997 and there is no grandfathering for this revised position.

In our view, the parties involved in such transactions would not have significantly relied on our position in IT-430R2 in pledging the life insurance policies as collateral security for loans. As well, the transactions can be restructured at a minimal cost. If there are any particular hardship cases, we would be prepared to consider these on a case by case basis.

QUESTION 15

At the 1996 CALU annual meeting, Revenue Canada indicated that income replacement benefits received by an individual under a disability insurance policy may be included in the individual's income pursuant to paragraph 56(1)(d) of the Income Tax Act. Can Revenue Canada update CALU members on the current status of this issue?

RESPONSE

It is possible that periodic payments received by an individual who is permanently disabled would be subject to paragraph 56(1)(d) of the Income Tax Act. Based on our understanding that the inclusion of these payments in income is not intended we are continuing discussion with the Department of Finance in conjunction with their review of insurance policies. In the meantime we will maintain our current practice which has been not to apply paragraph 56(1)(d) of the Income Tax Act to include periodic payments received under a disability policy in the recipient's income. Any change in the application of paragraph 56(1)(d) of the Income Tax Act to these periodic payments would only be made on a prospective basis.