The valuation of life insurance policies for the purposes of Canadian tax law is subject to a confusing set of rules and interpretations. In some instances, specific provisions in the Income Tax Act (the Act) apply, and in others, more general provisions may or may not apply. Regardless, these rules are subject to the interpretation of the Canada Revenue Agency
(CRA), whose pronouncements can be inconsistent and difficult to reconcile.
Let’s focus on the rules that apply where a private corporation owns a policy on the life of a deceased shareholder. In this case, subsection 70(5.3) of the Act provides relatively clear rules. Predictably, there are circumstances that fall outside of the specific wording of this provision and which should be identified.
(CRA), whose pronouncements can be inconsistent and difficult to reconcile.
Let’s focus on the rules that apply where a private corporation owns a policy on the life of a deceased shareholder. In this case, subsection 70(5.3) of the Act provides relatively clear rules. Predictably, there are circumstances that fall outside of the specific wording of this provision and which should be identified.
- General Application of Subsection 70(5.3)
on a Shareholder’s Death
Section 70 of the Act contains a lengthy list of provisions
dealing with a taxpayer’s death. In the case of capital
property, such as shares of a private corporation, a
disposition is deemed to occur immediately before the
shareholder’s death. To the extent that the shares’ fair
market value (FMV) at that time exceeds their adjusted
cost base (ACB), a capital gain will be recognized in the
deceased’s terminal return. Similarly, a capital loss will be
realized where the shares’ ACB is greater than FMV.
As readers will be aware, the above is subject to
exceptions that apply where shares are transferred to
a surviving spouse or common-law partner, or to a
qualifying trust for such person. In that case there is a
“rollover” that defers the realization of any capital gain
or loss to the death of the surviving spouse or partner.
Subsection 70(5.3) specifically deals with the valuation
of shares deemed to have been disposed of on death,
where the corporation owned insurance on the life of
the deceased or on the life of an individual with whom
the deceased did not deal at arm’s length at the time the
policy was issued (such as the deceased’s spouse, sibling,
or child). Where the subsection applies, the FMV of the
shares will be determined as though the FMV of the
relevant policy was its cash surrender value (CSV). For
these purposes, policy loans are essentially ignored, and
are therefore included in the CSV. Unpaid dividends and
the CSV of paid-up additions are also included.
These rules were introduced following the 1977 Federal
Court of Appeal decision in the case of Mastronardi v.
The Queen. In that case, the taxpayer successfully
challenged the CRA’s position that the death benefit
under a corporate-owned term insurance policy should
be considered in valuing the deceased’s shares.
The Court held that no insurance proceeds were
payable “immediately before death,” and that as a result
the amount of the proceeds should not be considered
in valuing the deceased’s shares under the deemed
disposition rules. Subsection 70(5.3) essentially codifies
the Mastronardi decision, although with certain limitations
that will be addressed below. - Technical and Planning Considerations
a) Limitations on the Scope of Subsection 70(5.3)
As described above, subsection 70(5.3) applies to policies
on the life of the deceased and certain non-arm’s length
parties. It does not, however, apply in a number of other
circumstances. Let’s look at three examples where the
subsection would not apply:
Example 1
Assume that A is the sole shareholder of a corporation
that owns insurance on A’s life. The corporation also
owns a “key person” policy on B, a person who is a key
employee but not a shareholder, and with whom A deals
at arm’s length. On A’s death, subsection 70(5.3) will
apply in valuing the policy on A’s life. It will not, however,
apply in determining the value of the policy on B’s life.
Therefore, the FMV of A’s shares immediately before
death will include the CSV (if any) of the policy on A’s
life, but the policy on B’s life, as it impacts the value of A’s
shares, will be valued under general valuation principles
(see discussion in Example 3).
Example 2
The inclusion of insurance on the life of non-arm’s
length parties within subsection 70(5.3) applies only
where that relationship existed at the time the policy on
the deceased’s life was issued. There could be (admittedly
rare) circumstances where there was an arm’s length
relationship when the policy was issued, but the parties
became non-arm’s length at a later date. For example,
if A and B in the above example were originally arm’s
length parties, but were married after the policy on A’s
life was issued, subsection 70(5.3) would still not apply
in valuing the policy on B’s life at the time of A’s death.
(Any resulting increase in A’s share value would not be of
concern, however, if A’s shares were transferred to B on a
tax-deferred basis following A’s death.)
Example 3
Assume that three arm’s length shareholders, X, Y,
and Z, are equal shareholders of a corporation. The
corporation acquired insurance on all three lives for
the purposes of buy-sell funding. Assuming X was
the first to die, subsection 70(5.3) would theoretically
apply regarding the corporate-owned policy on his
life, but not regarding the policies on his arm’s length
co-shareholders, Y and Z. This may, however, be simply
an academic point, as the valuation formula under the
shareholders agreement would likely override subsection
70(5.3), i.e., the FMV of the deceased’s shares would
be based upon a binding agreement that, in most cases,
should specifically exclude life insurance proceeds from
the purchase price.
b) Valuation where 70(5.3) Does Not Apply
Where subsection 70(5.3) does not apply, an insurance
policy would be valued on general valuation principles.
These would presumably apply in valuing the policy
on B’s life, at the time of A’s death, in Example 1.
The valuation would likely require the services of an
independent actuary. The CRA’s views on the valuation
of life insurance policies are provided in Information
Circular IC 89-3 and would be important in any
valuation performed by an independent actuary.
The key factors identified in the circular are as follows:
• the CSV of the policy;
• the loan value of the policy;
• the face value of the policy;
• the state of health of the life insured
and his or her life expectancy;
• the policy’s conversion privileges;
• replacement value; and
• the perceived imminence of death.
c) CRA Commentary on Shared Ownership
Under a typical shared ownership agreement, ownership
of a life insurance policy is shared between one party
who requires the life insurance coverage (typically a
corporation) and another who has longer term needs
(typically the shareholder). The costs and benefits of
the policy are shared by the parties in accordance with
a shared ownership agreement. Generally, the death
benefit owner (the corporation) will pay an amount
reflecting insurance charges under the policy, and will
designate a beneficiary for the policy’s face amount.
Deposits to the policy’s investment accounts will be made
by the cash value owner (the shareholder), who will
designate a beneficiary for that portion of the policy.
In a recent roundtable presented by the Conference
for Advanced Life Underwriting, the CRA was asked
to comment on the potential application of subsection
70(5.3) in a shared ownership arrangement. The
question concerned whether the policy’s CSV would
be included in the value of shares owned by a deceased
shareholder where, under the shared ownership
arrangement, the CSV had been owned by the deceased.
In its response, the CRA noted that subsection 70(5.3)
does not specifically refer to policies where there is more
than one ownership interest, and was unable to state
definitively that the value of the corporation’s interest
would be nil. It appears that the CRA is concerned
about certain situations where the corporation is “quick
paying” premiums and, as a consequence, benefiting or
subsidizing the shareholder. In its response, the CRA
stated that “the terms and conditions of the shared
ownership arrangement, the specific life insurance
contract and all other related agreements which may
form part of the particular arrangement and the
particular facts at the given time would have to be
considered. …”
It is hoped that the corporation’s interest in the policy
will be valued at nil for the purposes of subsection
70(5.3), in an arrangement where the corporation’s
share of the premiums more accurately reflects the
actual annual cost of insurance, and does not benefit the
shareholder in any way. In this regard, shared ownership
arrangements will be considered on a case-by-case basis
and need to be structured carefully. ©
Copied with permission from The Institute of Advanced Financial Education. Written by Glenn Stephens, LLP, TEP, FEA, vice-president,
planning services at PPI Advisory.