By: Florence Marino B.A., LL.B., TEP | Vice President, Tax & Estate Planning
Life insurance is a unique asset. Most times that’s a good thing. Sometimes it’s a challenge. When it comes to divisive reorganizations, life insurance can be a challenging asset to deal with from a tax point of view.
A common situation
G1 has successfully passed on family business wealth to G2. G2 – 3 siblings, hold shares of Holdco. Holdco owns permanent life insurance policies with cash value on each of the 3 siblings. With G1 no longer alive, G2 is eager to go their separate ways. The goal is to split up Holdco on a tax deferred basis using a divisive reorganization (“butterfly”). This is possible through a combination of different sections of the Act, namely, subsection 85(1), 84(3) and 112(1). Butterflies must navigate complex denial and anti-avoidance provisions and often involve getting an Advanced Income Tax Ruling.
Why is life insurance a challenge?
First, a tax deferred transfer may not be possible. Secondly, the value of different life insurance policies may not be proportional and lastly, the classification of life insurance as an asset type further complicates the proportionate share allocation of each different asset type under the butterfly rules.
Life insurance is not “eligible property” for purposes of subsection 85(1) of the Act. As such, when a policy is transferred out of a corporation either as a distribution, for no consideration or to a non-arm’s length party, subsection 148(7) deems the proceeds of the disposition of the policy to be the greatest of the policy’s adjusted cost basis (ACB), cash surrender value (CSV) and the fair market value (FMV) of consideration given. Since a double winged butterfly transaction involves the transfer of assets to new corporations owned by each of the shareholders (Newco), there may be a taxable policy gain on the transfer (T5 – ordinary income) if the proceeds of disposition exceed the ACB of the policy. The transfer could also give rise to potential tax consequences for the transferee corporation. Typically, in a butterfly transaction the policy is transferred as a dividend in-kind from Holdco to each NewCo as a tax-free intercorporate dividend. Provided there is sufficient safe income in Holdco there would be no tax implication for NewCo.
The difference in values between different policies and the classification of the policy into different asset types can also add complexity. The CRA has commented on the classification of life insurance policies as an asset type in 2011-0399401C6. In general, it considers the CSV of a life insurance policy to be “cash or cash equivalents” and the excess of the policy’s FMV over the CSV to be “investments” or “business property”. However, the classification of asset type is highly dependent upon client facts. Challenges can also arise if one of the shareholders has serious health problems making the FMV of the policy on them significantly higher than the policies on the other shareholders.
These challenges are not impossible to navigate but do require care. For an example of a CRA ruling involving a life insurance asset applying the principles outlined above see 2017-0714411R3.
Is it possible to plan for this in advance?
When putting corporate owned life insurance in place, it is important to determine which corporation in the corporate group should hold the insurance and to contemplate if a divisive reorganization is in the cards – in the short term or longer term. Check in on this possibility as the corporate structure changes and as life events occur. It may not be possible to foresee all contingencies but keeping an eye on it can allow for planning before things become entrenched.
FOOTNOTE:
This publication is protected by copyright. Tompkins Insurance is not engaged in rendering tax or legal advice. TOMPKINSights contains a general discussion of certain tax and legal developments and should not be construed as tax or legal advice.
Should you wish to discuss this or any other TOMPKINSights article, please contact
florence@tompkinsinsurance.com
