Where a post-mortem pipeline entails an s. 88(1)(d) bump, any CDA from life insurance should be paid out before Newco is introduced to the structure

In post-mortem pipeline transactions, the estate might transfer shares of “Investco” to “Newco” in exchange for a Newco promissory note, with Investco and Newco subsequently being amalgamated, thereby permitting access to bump treatment under s. 88(1)(d). However, the availability of the bump may be adversely affected if life insurance proceeds received by Investco were distributed out of its capital dividend account (CDA) to Newco (in turn, distributed by Newco to the estate).

In this regard, s. 88(1)(d)(i.1) provides that the cumulative bump room will be further reduced by not only taxable dividends that are deductible under s. 112 but also capital dividends received. Accordingly, the payment of a substantial capital dividend out of the CDA of Investco arising from the life insurance death benefit may entirely eliminate the bump room pursuant to s. 88(1)(d)(i.1)(B).

The purpose of s. 88(1)(d)(i.1) is to prevent the payment of tax-free dividends without any corresponding reduction in share basis so as to artificially increase the available bump room. However, applying s. 88(1)(d)(i.1) to capital dividends arising from life insurance implicitly assumes that a tax-free distribution has reduced inside basis without affecting outside basis, where, in fact, no outside basis was ever attributable to the insurance proceeds, i.e., the provision does not distinguish between capital dividends representing previously taxed economic value and those arising solely from statutory non-taxable amounts.

This anomaly can be avoided if the life insurance proceeds are paid out of the Investco CDA to the estate before Newco is introduced as part of the pipeline transaction.

Neal Armstrong. Summary of Henry Shew and Florence Marino, ”The interaction between corporate-owned life insurance and bump transaction,” Tax for the Owner-Manager, Vol. 20, No. 2, April 2020, p. 3 under s. 88(1)(d)(i.1).