12 May 1998 CALU Roundtable Q. 1, 9807000 - CONFERENCE OF ADVANCED LIFE UNDERWRITING

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: See attached

Position: See attached

Reasons: CALU Conference/Questions and Answers

THE CONFERENCE FOR ADVANCED LIFE UNDERWRITING

May 1998

Question 1

Revenue Canada's long-standing policy on the deductibility of shareholder bonuses is that a bonus will not be considered to be unreasonable where:

(a) the recipient is a principal shareholder-manager of the corporation and

(b) the corporation's general practice is to distribute its profits to shareholder-managers in the form of bonuses, or

(c) the company has adopted a policy of declaring bonuses to shareholders to remunerate them for the profits the corporation has earned that are attributable to the special know-how, skill, connections or entrepreneurial skills of the shareholders.

The Department has also applied these same tests to determine the reasonableness of a contribution made by a company to an RCA established to provide post-retirement benefits to a shareholder-manager. Can you confirm that this continues to be Revenue Canada's policy?

Department's Position

The Department stated, in its comments in part 3 of its response to Question 42 of the 1981 Canadian Tax Foundation Revenue Canada Round Table, that, in general, it will not challenge the reasonableness of salaries and bonuses paid to the principal shareholder-managers in the situation described above. Although the response relates to the payment of salaries and bonuses to principal shareholder-managers of a Canadian-controlled private corporation, we confirm that this position also applies equally to the determination, for the purposes of section 67 of the Act, of the reasonableness of a contribution made by a company to an RCA in respect of benefits to be received by its principal shareholder-managers.

We note, however, that it is a question of fact whether an arrangement which an employer is funding would constitute an RCA or a salary deferral arrangement, within the meaning assigned by subsection 248(1) of the Act. This issue is addressed in question 2.

THE CONFERENCE FOR ADVANCED LIFE UNDERWRITING

May 1998

Question 2

In various technical interpretations dealing with funded arrangements for shareholder-managers, Revenue Canada has stated that it is a question of fact whether the arrangement is a "retirement compensation arrangement" (RCA) or a "salary deferral arrangement" (SDA). Can the Department provide any guidelines in this regard? In particular:

(a) To be an SDA, one of the main purposes for the arrangement must be to postpone tax payable under the Income Tax Act. If the arrangement would otherwise be an RCA which is subject to federal tax at the rate of 50%, how could it be said that a main purpose of the arrangement was to postpone tax when the maximum rate of federal tax payable on the deferred compensation would have been only 29% (plus relevant surtax)?

(b) Where a corporation's general practice has been to distribute its profits in excess of $200,000 per annum to the shareholder - managers in the form of additional salary or bonuses, will a change in this practice to contribute all or a part of such excess profits to a funded plan providing post-retirement benefits for the shareholder - managers be considered, in and of itself to be an SDA?

(c) To avoid the characterisation of a funded arrangement for shareholder - managers as an SDA, will it be necessary to demonstrate that the plan is substantially similar to either a defined benefit or a defined contribution pension plan? If so can the Department provide any guidelines as to how a reasonable amount of retirement benefits might be determined, having regard to the fact that the compensation paid to shareholder - managers over their careers is typically dependent on the profitability of the corporation and may vary significantly from year to year.

Department's Position

The definition of an RCA specifically excludes any plan that is an SDA. Accordingly, under the scheme of the act, any arrangement that could otherwise qualify as both an RCA and an SDA will be treated as an SDA. In our view, this approach is consistent with other tax policy measures to not allow for income averaging. Although the immediate tax collected by the fisc in treating an arrangement as an SDA or RCA may effectively be the same (if an individual's marginal tax rate approximates 50%), payments may ultimately be made from an RCA when the individual's tax rate is below the current marginal rate of 50%, effectively allowing income averaging.

With respect to the three particular concerns we can comment as follows:

(a) An SDA may arise when one of the main purposes for the creation or existence of the right is to postpone tax payable by a taxpayer in respect of an amount that is, or is on account or in lieu of salary or wages. The tax referred to in the purpose test does not include the refundable RCA tax.

(b) Generally we would expect that if it has been the practice of an employer to pay a portion of its profits as additional salary or wages to a shareholder-manager, it may be reasonable to treat the arrangement resulting from the change in practice as an SDA. Again this determination would be a question of fact.

(c) An RCA does not have to be structured in any particular manner to avoid the SDA rules. However, an arrangement designed to supplement the maximum benefits allowed to be paid to employees on or after retirement under a registered pension plan would be considered a pension plan. In general, a funded and unregistered pension plan will not meet the definitions of a salary deferral arrangement but will be a retirement compensation arrangement.

THE CONFERENCE FOR ADVANCED LIFE UNDERWRITING

May 1998

Question 3

In a letter to the Winnipeg Tax Services Office in December 1997 (973006), the rulings directorate expressed the view that;

"Where an employer makes a payment to a third party and the funds are effectively returned to the employer, either as a loan or investment in its shares, it is questionable whether the payment was made in connection with benefits to be received on retirement."

It was also indicated that;

The function of an RCA is to secure certain obligations of an employer. If the purpose of a series of transactions does not satisfy this function it can not be said that the arrangement is an RCA."

Please describe the factors that will be relevant in determining whether such arrangements will be considered to be RCAs.

Department's Position

It is a question of fact whether an arrangement is an RCA or some other form of arrangement. Because these types of arrangements are relatively new and exist in a number of formats we are not able to provide a list of factors that will be relevant to this kind of determination at the present time. However, the Department's basic concern is what is the purpose of the series of transactions when the amounts paid to the RCA are returned in one form or another to the employer. We may question whether or not an RCA exists, as contributions under the arrangement may not be made in connection with benefits that are to be received by the taxpayer.

The issue is whether or not the purpose of the arrangement is to provide benefits to the employee after retirement, or whether there is some other purpose for the series of transactions.

THE CONFERENCE FOR ADVANCED LIFE UNDERWRITING

May 1998

Question 4

Where an RCA incurs interest expenses in respect of borrowed money used for the purpose of earning investment income, would paragraph 20(1)(c) of the Act prohibit the interest expenses related to such debt from being deductible in computing the RCA's income for the purposes of determining its refundable taxes under Part XI.3 of the Act?

Department's Position

The fact that paragraph 149(1)(q.1) exempts an RCA from being taxed under Part I of the Act on its taxable income does not, in and by itself, result in the income earned by the RCA being classified as exempt income for purposes of paragraph 20(1)(c) of the Act. The fact that an RCA is not taxed under Part I of the Act does not mean it cannot earn taxable income. Therefore, where an RCA incurs interest expenses in respect of debts incurred to earn investment income, the interest expenses would be deductible in computing the RCA's income for the purposes of computing its refundable taxes provided that all of the other conditions in paragraph 20(1)(c) of the Act are satisfied. This question has not been raised previously with this Directorate and thus we are not aware of the reasons why an RCA trust would be borrowing money.

THE CONFERENCE FOR ADVANCED LIFE UNDERWRITING

May 1998

Question 5

Where an employer makes a bona fide loan to an RCA trust:

(a) Will the loan be considered to be a "contribution" under the arrangement for purposes of calculating the refundable tax of the RCA?

(b) If the RCA has been established for the benefit of a shareholder, will the amount of the loan be included in the shareholder's income pursuant to subsection 15(2)?, and

(c) Will subsection 80.4 apply for purposes of determining whether an imputed interest benefit is included in the income of the employees who are beneficiaries of the RCA?

Department's Position

(a) A loan could be a contribution. The Department has considered this issue in only one scenario. In that situation, the employer loaned an amount equal to the refundable taxes to the RCA in order to facilitate the wind-up of the RCA and, as such, the loan was not considered to be a contribution to the RCA. The facts in respect of each situation would have to be reviewed to determine whether a particular loan would constitute a contribution for purposes of Part XI.3 of the Act.

(b) Where it is determined that the shareholder is connected to the RCA trust and the bona fide loan is not considered a contribution, the loan to the RCA established for the benefit of the shareholder would be included in the RCA's income pursuant to subsection 15(2) of the Act. Pursuant to subsection 15(2.1), a shareholder would be connected with the RCA trust where they do not deal at arm's length. The determination of whether a beneficiary of a trust and the particular trust deal at arm's length is dealt with in paragraph 22 of Interpretation Bulletin IT-419R.

(c) As a result of the application of paragraph 80.4(3)(b), section 80.4 would not apply to loans made to an RCA that have been subjected to subsection 15(2) in situations described in (b) above. However, section 80.4 could apply to loans made by an employer to an RCA established for the benefit of its employees.

THE CONFERENCE FOR ADVANCED LIFE UNDERWRITING

May 1998

Question 6

The use of a split dollar arrangement in the context of an RCA trust is becoming more prevalent. Has Revenue Canada taken any position with respect to the possible income tax implications of such arrangements?

Department's Positions

We were asked at the 1992 CALU Annual Meeting to comment on the assessing practice of Revenue Canada in respect of jointly-owned split dollar insurance policies by the corporation and/or the employee or shareholder (the original owner of the insurance policy having assigned to the other person specific rights under the policy) and whether or not a shareholder-employee could receive a benefit which would be included in income pursuant to paragraph 6(1)(a) or subsection 15(1). Even though this determination is a question of fact we attempted to provide general comments such that taxpayers would have an understanding of our approach. We therefore commented that generally our position was that at the time the specific rights under the policy were assigned by the original owner of the policy, for example the corporation, the original owner would be disposing of an interest in the life insurance policy and would be subject to the provisions of section 148 and paragraph 56(1)(j). In addition, the fair market value of the specific rights which were being assigned by the corporation to the shareholder or employee in excess of the consideration, if any, which would be paid by the shareholder or employee for such rights would constitute a taxable benefit pursuant to paragraph 6(1)(a) or subsection 15(1). We noted, however, that the final determination of the income tax implications of such assignments can only be made on a case by case review of the terms of the particular insurance policy and the rights which have been made available to someone other than the original owner of the policy. We then noted that it is a question of fact whether or not the shareholder or employee would receive an additional benefit, subsequent to the above assignment. We noted that no taxable benefit would arise where the premium paid by the shareholder or the employee under the policy is equal to the premium for comparable rights available in the market under a separate insurance policy.

It is our understanding that the type of split-dollar arrangements which are now available have evolved from the so-called conventional split dollar insurance policies and have become very innovative. We are also of the view that the nature of the specific life insurance policies presently used in split dollar arrangements, which we understand can include universal life insurance policies, need to be taken into consideration in this matter. The terms and conditions of universal life insurance policies are so flexible that they can only be commented on by reviewing a specific universal life insurance contract. As well, as was indicated by Mr. Glenn R. Stephens in a recent paper presented at the Innovative Uses of Insurance Conference (Federated Press) with respect to split dollar insurance arrangements "the types of possible arrangements are limited only by the imagination of the parties and the terms of the insurance contracts." Mr. Stephens also stated in his paper that "split dollar is a marketing concept rather than a specific arrangement which is designed the same way each time. For this reason, complete documentation, prepared at the onset, is critical to ensuring that a proper plan is implemented."

Consequently, it could prove to be misleading if we were to make general comments which might be totally inappropriate in some factual cases in light of the nature of the products and arrangements presently available in the market. However, we are willing to review specific proposed arrangements and we will comment accordingly as to the possible income tax implications. It is necessary that we be provided with all the relevant agreements and the life insurance policies and all the related documentation and agreements which will form part of the split dollar arrangement in the context of an RCA trust. It may then be possible for our Department following the review of a number of specific proposed arrangements to perhaps be in a position to develop some general comments with respect to such arrangements.

THE CONFERENCE FOR ADVANCED LIFE UNDERWRITING

May 1998

Question 7

Property held by an RCA trust may revert to the employer corporation that settled the trust (e.g., where employees do not satisfy vesting requirements). In addition, where an RCA trust has been established to fund retirement benefits for a group of employees, new beneficiaries will be added to the plan from time to time after the trust was created.

In such circumstances, will the attribution rules in subsection 75(2) apply to deem the income from the property of the RCA trust to be income of the employer corporation?

If so, will such income and capital gains also be included in determining the refundable tax of the RCA trust?

Department's Position

In these circumstances, the attribution rules in subsection 75(2) will apply to deem the investment income and taxable capital gains of the RCA trust to be income of the employer corporation.

Although, subsection 75(2) does not apply to property held by one of the trusts listed in subsection 75(3), an RCA trust, other than a non-resident trust, is not listed as an exception under 75(3).

The Department of Finance has been advised of this situation.

Income from property or a capital gain from disposition of property held by an RCA trust that would be deemed to be the employer corporation's income or capital gain under subsection 75(2) would generally not be considered to be the RCA trust's income or capital gain for purposes of determining refundable tax in subsection 207.5(1).

THE CONFERENCE FOR ADVANCED LIFE UNDERWRITING

May 1998

Question 8

Where a corporation was the beneficiary of an insurance policy on the life of a shareholder on April 26, 1995, grandfathering from the application of the stop-loss provisions will be available provided the taxpayer can demonstrate that certain conditions related to the policy existed on that date. In the latest edition of the Income Tax Technical News (No. 12) published by the Policy and Legislation Branch, the Department has offered some general comments to assist taxpayers in determining whether the grandfathering provisions will apply. Included in the Department's comments is the statement:

"It is possible that subsequent actions in respect of the policy may be relevant in determining whether the requirements (i.e. the main purpose test) set out in the proposed grandfathering provisions ... relating to the life insurance policy existed on April 26, 1995."

Will the Department provide examples of the situations where "subsequent actions" in respect of a policy may be viewed as evidence that the conditions did not exist on April 26, 1995?

Department's Position

In most cases we would expect that documentation such as buy-sell agreements or corporate documents would indicate whether a main purpose of the life insurance policy at April 26, 1995 was to fund a redemption, acquisition or cancellation of shares by the corporation that issued the shares. Where there is no clear evidence of the main purpose of a life insurance policy at April 26, 1995 the actual use of the proceeds, or if the policy is subsequently cancelled or allowed to lapse, the circumstances surrounding such a decision, may be indicative of whether the purpose of the life insurance policy on April 26, 1995 was to fund the redemption of shares.

Clearly subsequent events cannot substitute or overrule documentary evidence existing at April 26, 1995 but where such evidence is lacking the Department may be prepared to consider subsequent actions as corroborative evidence. Each such situation will be reviewed on its own merits.

THE CONFERENCE FOR ADVANCED LIFE UNDERWRITING

May 1998

Question 9

Where an individual makes a charitable gift of a non-qualifying security, for purposes of determining the individual's tax credit, the gift is deemed not to have been made unless and until either the security ceases to be a non-qualifying security or the security is disposed of by the donee within 60 months after the security was transferred to the donee. Because of these provisions, as a condition of making the gift, an individual may require that the donee agree to dispose of the security in the required time frame.

Will such a condition, in and of itself, be viewed as "consideration" and, hence, disqualify the transfer as a gift?

Department's Position

The Department would not, generally, consider that such a condition would constitute "valuable consideration" received by the donor so as to disqualify the transfer as a "gift".

THE CONFERENCE FOR ADVANCED LIFE UNDERWRITING

May1998

Question 10

A gift to a public charity of a non-qualifying security that is a share will qualify as an "excepted gift" if, among other conditions, the donor deals at arm's length with the donee.

Interpretation Bulletin IT-419R includes the Department's general guidelines for determining whether there is an arm's length relationship between unrelated persons for a given transaction. However, these guidelines relate primarily to commercial transactions and do not seem to be appropriate in a charitable giving context where there is a community of interests between the donor and the charity.

What factors will the Department consider when determining whether a donor and the recipient of the gift deal with each other at arm's length?

Department's Position

Determining whether or not two unrelated persons are dealing at arm's length at any given time is a question of fact. While the Department provides general criteria to determine whether there is an arm's length relationship between unrelated persons for a given transaction (see IT-419R), it must be recognized that all encompassing guidelines to cover every situation cannot be supplied. Each particular transaction or series of transactions must be examined on its own merits.

This examination should take into account the general guidelines set forth in paragraphs 15 to 19 of IT-419R. These guidelines would apply in determining whether a donor and the recipient of the gift deal with each other at arm's length. However, as stated in paragraph 17 of IT-419, when a common purpose exists, a transaction is not necessarily a non-arm's length one when different interests (or independent parties) are also present. In this context, different interests are considered to exist when each party has an independent interest from the other parties to a transaction, notwithstanding the fact that each party may have the same purpose, such as the same charitable objectives.

THE CONFERENCE FOR ADVANCED LIFE UNDERWRITING

May 1998

Question 11

One of the other conditions for a donation of a non-qualifying share to a charitable organization or a public foundation to be an "excepted gift", is that the donor "deals at arm's length with each director, trustee, officer and like official of the donee".

(a) If a donor is a director or trustee but deals at arm's length with each other director, trustee, officer and like official of a charity, is the above-noted condition satisfied?

(b) If the condition is not satisfied but the donor resigns as a director or trustee shortly before the donation is made, is the above-noted condition satisfied?

(c) If a donor deals at arm's length with each director, trustee, officer and like official of a charity at the time the gift is made, but shortly thereafter (perhaps as a result of having made the gift) becomes a director or a trustee, is the above-noted condition satisfied?

Department's Position

As a preliminary comment, we would note that, as provided in paragraph 251(1)(b) of the Income Tax Act (the "Act"), it is a question of fact whether unrelated persons deal with each other at arm's length. The Department's general views on the question of whether unrelated parties deal at arm's length are set out in paragraphs 15 to 19 of Interpretation Bulletin IT-419R. Accordingly, in the situations described above, the fact that the donor may not be related to the other directors or trustees would not, in and of itself, be conclusive as regards the question of whether the donor "deals at arm's length with each director, trustee, officer and like official of the donee". For purposes of our response to the questions set out above, we have assumed that the facts are such that the donor in fact deals at arm's length with each other director, trustee, officer and like official of the donee.

(a) Where the donor is a director or trustee at the time the gift is made, proposed paragraph 118.1(19)(d) would not be satisfied notwithstanding that the donor deals at arm's length with each other director, trustee, officer and like official of the charity.

(b) Where such a donor resigns as director or trustee of a charity prior to making a gift, proposed paragraph 118.1(19)(d) may be satisfied provided that the donor otherwise deals at arm's length with each director, trustee, officer and like official of the donee. In determining whether this provision would be satisfied, the Department would consider whether the resignation is such that the donor has severed all ties as a director or trustee with the board of directors or trustees and whether there is an intention to reinstate the donor as a director or trustee shortly after his or her resignation.

(c) Since the gift that we are concerned with is a share of the capital stock of a corporation with which the donor does not deal at non-arm's length, we may have a concern where the donor becomes a director or trustee shortly after making the gift, that the two transactions are linked such that the donor would be considered to deal at non-arm's length at the time the gift was made. Having said that, we recognize that there may be circumstances where there would be no cause for concern such as where the director's actions are independant from the making of the gift.

THE CONFERENCE FOR ADVANCED LIFE UNDERWRITING

May 1998

Question 12

Interpretation Bulletin IT-226R outlines the Department's views as to the requirements that must be met for a donation of an equitable interest in a trust to qualify as a gift for tax purposes. Such trusts are commonly referred to as "charitable remainder trusts".

Where the requirements of IT-226R are met, will the Department confirm that the remainder interest in a charitable remainder trust is not a "non-qualifying security" as defined in proposed subsection 118.1(18) of the Act?

Department's Position

In our view, the remainder interest in a charitable remainder trust is not a security described in any of paragraphs (a) to (c) in the definition of "non-qualifying security" in proposed subsection 118.1(18) of the Act. Accordingly, we confirm that it is not a "non-qualifying security" for the purposes of sections 110.1 and 118.1 of the Act. However, if, having regard to the circumstances, it is determined that the main reason for using a charitable remainder trust is to circumvent the rules in proposed subsection 118.1(13) or (16) of the Act, consideration will be given to the possible application of GAAR, e.g., where the assets transferred to the trust are themselves non-qualifying securities.

THE CONFERENCE FOR ADVANCED LIFE UNDERWRITING

May 1998

Question 13

Assume that Father owns all the shares of Holdco. He also holds a promissory note issued by Holdco.

Holdco holds a promissory note issued by Opco. Father controls Opco through the ownership of voting redeemable preferred shares. The common shares of Opco are owned by Father's children.

Father makes a donation of all of the shares of Holdco and the promissory note issued by Holdco to a registered charity.

Will the donation of the shares and the note by father be considered to be a gift of non-qualifying securities ?

Department's Position

As Father and Holdco will not be related immediately after the gift, and provided that they in fact otherwise deal at arm's length immediately after the gift, the provisions of paragraphs 118.1(18)(a) and (b) will not be applicable. However, GAAR may be an issue in this case if it can reasonably be concluded that the real gift to the charity is the promissory note of OPCO.

THE CONFERENCE FOR ADVANCED LIFE UNDERWRITING

May 1998

Question 14

Assume that Father owns all of the preferred ( non-voting) and common shares of Opco. Father dies and under the terms of his will, he makes a gift of the preferred shares to a registered charity. The common shares are then distributed to the beneficiaries and the estate is wound up.

In the first instance, presumably the testamentary gift would be considered to be a gift of non-qualifying securities because Father's estate would not deal at arm's length with Opco immediately after Father's death. However, when the estate is wound up, the preferred shares would cease to be a non-qualifying security because neither Father nor the estate could be said not to be dealing at arm's length immediately thereafter.

Consequently, provided that the estate is wound up within 60 months after the date of death, it would appear that the gift would qualify for a tax credit in the Father's terminal return.

Does the Department agree with this interpretation of the application of the provisions of proposed subsection 118.1(5), (13), (15), and (18)? If so, will the fair market value of the gift be the fair market value of the preferred shares immediately before death or the lesser of such value and the fair market value of the preferred shares at the time they cease to be non-qualifying securities?

Department's Position

Pursuant to proposed subsection 118.1(13), if an individual makes a gift of a non-qualifying security, that gift will be ignored for the purpose of the charitable donation tax credit. However, if the security ceases to be a non-qualifying security of the individual within 60 months, the individual will be treated as having made a gift at that later date.

In the case where the individual makes the gift by the individual's will, the gift is deemed by subsection 118.1(15) to have been made by the individual in the taxation year in which the individual died.

Pursuant to proposed paragraph 118.1(13)(b) the fair market value of the gift will be the lesser of the fair market value at the time it ceases to be a non-qualified security and the fair market value at the time of the original gift.