The 2016 Federal Budget introduced legislative changes to the calculation of the capital dividend account in respect of life insurance proceeds received by a corporation.
The new rules require that the credit to the capital dividend account arising from the receipt of life insurance proceeds be calculated as the amount of life insurance proceeds received in excess of a policyholder’s adjusted cost basis (ACB) of the policy. This means that the policy’s ACB will be used in the calculation regardless of the relationship of the beneficiary to the policy owner.
For example, assume a holding company (Holdco) owns a life insurance policy and names its subsidiary (Opco) as the beneficiary of the policy. When Opco receives the life insurance proceeds, it will calculate the credit to its capital dividend account as life insurance proceeds received in excess of Holdco’s ACB. If the life insurance proceeds paid to Opco are $100,000 and Holdco’s ACB is $7,500, the credit to Opco’s capital dividend account is $92,500 ($100,000 of proceeds less the policy’s ACB of $7,500).
At a recent Canada Life and Health Insurance Association meeting, a question was posed to the Canada Revenue Agency (CRA) requesting clarification of this provision. The CRA was asked what the result would be if a holding company owned a life insurance policy and named two of its subsidiaries, OpcoA and OpcoB, as equal beneficiaries of the life insurance policy. Since there was only one life insurance policy and one ACB, the industry was looking for the CRA’s view on how the ACB would be allocated in this particular circumstance.
To the surprise of many, the CRA’s response was that when there are multiple beneficiaries designated under a single policy it was their view that each beneficiary would include the entire ACB in the calculation of their capital dividend account. Applying the CRA’s approach, the credit to the capital dividend account is reduced multiple times by the same amount (policy ACB) when there is more than one corporate beneficiary.
Using the CRA’s view, let’s look at an example. Holdco owns a life insurance policy that results in the payment of $100,000 of proceeds divided as 60% and 40% to the two operating companies owned by Holdco. OpcoA receives $60,000 and OpcoB receives $40,000. Holdco’s ACB is $7,500 at the time the life insurance proceeds are paid. Below is a summary of how the CDA credit will be calculated.
OpcoA OpcoB TOTAL
Life insurance proceeds received $60,000 $40,000 $100,000
Less: A policy-holder’s adjusted
cost basis $7,500 $7,500 $7,500
Credit to their capital dividend
account $52,500 $32,500 $85,000
The CRA’s view reflects a strict reading of the provision. The provision as drafted does not appear to contemplate possible business scenarios, particularly as it relates to multiple beneficiary situations. Consider the following examples of situations where the CRA’s view creates an unfair outcome.
Example One
A parent is the owner of Holdco, which in turn owns a life insurance policy and fixed value preferred shares of OpcoA and OpcoB. The common shares of OpcoA and OpcoB are owned by different children each with their own business plan. The life insurance owned by Holdco names OpcoA and OpcoB as beneficiaries of the policy.
The purpose of this arrangement is to fund a redemption of the preferred shares. By redeeming the preferred shares, each child gains independence from the family and the value of preferred shares in Holdco is converted to cash to support the other estate planning needs of the parent.
In this example, the children were active in the family-owned business and a transfer of ownership from the parent is a logical and valid business and succession plan. It is common and a reasonable strategy for family businesses to use life insurance to help fund succession costs.
Example Two
A business owner might use a Holdco above several Opcos in order to creditor protect the situation by not holding hard assets in the operating companies. If one of the operating companies should need financial support, the arrangement is that Holdco would provide that support. One such way to provide support is to name the Opcos as beneficiaries for a portion of life insurance owned by Holdco. In this type of structure, an insurance arrangement is commonly required under each of the Opcos borrowing arrangements with their lenders.
Example Three
Two partners in business may hold their shares of Opco in each of their holding companies. Their buy-sell arrangement might say that each partner is to buy life insurance on their life and hold it in their individual Holdco naming Opco as beneficiary for the amount necessary to fulfill the buy-sell arrangement. Each of the partners could decide to buy extra insurance for individual needs or to have sufficient coverage should the value of Opco rise over time. Each of the Holdcos would name Opco for a portion of the insurance proceeds and their respective Holdco for the excess.
Even though there are legitimate reasons for naming multiple corporations as beneficiaries of a single life insurance policy, a conscious review of these arrangements would be advisable in light of the CRA’s position on this issue.
The new rules require that the credit to the capital dividend account arising from the receipt of life insurance proceeds be calculated as the amount of life insurance proceeds received in excess of a policyholder’s adjusted cost basis (ACB) of the policy. This means that the policy’s ACB will be used in the calculation regardless of the relationship of the beneficiary to the policy owner.
For example, assume a holding company (Holdco) owns a life insurance policy and names its subsidiary (Opco) as the beneficiary of the policy. When Opco receives the life insurance proceeds, it will calculate the credit to its capital dividend account as life insurance proceeds received in excess of Holdco’s ACB. If the life insurance proceeds paid to Opco are $100,000 and Holdco’s ACB is $7,500, the credit to Opco’s capital dividend account is $92,500 ($100,000 of proceeds less the policy’s ACB of $7,500).
At a recent Canada Life and Health Insurance Association meeting, a question was posed to the Canada Revenue Agency (CRA) requesting clarification of this provision. The CRA was asked what the result would be if a holding company owned a life insurance policy and named two of its subsidiaries, OpcoA and OpcoB, as equal beneficiaries of the life insurance policy. Since there was only one life insurance policy and one ACB, the industry was looking for the CRA’s view on how the ACB would be allocated in this particular circumstance.
To the surprise of many, the CRA’s response was that when there are multiple beneficiaries designated under a single policy it was their view that each beneficiary would include the entire ACB in the calculation of their capital dividend account. Applying the CRA’s approach, the credit to the capital dividend account is reduced multiple times by the same amount (policy ACB) when there is more than one corporate beneficiary.
Using the CRA’s view, let’s look at an example. Holdco owns a life insurance policy that results in the payment of $100,000 of proceeds divided as 60% and 40% to the two operating companies owned by Holdco. OpcoA receives $60,000 and OpcoB receives $40,000. Holdco’s ACB is $7,500 at the time the life insurance proceeds are paid. Below is a summary of how the CDA credit will be calculated.
OpcoA OpcoB TOTAL
Life insurance proceeds received $60,000 $40,000 $100,000
Less: A policy-holder’s adjusted
cost basis $7,500 $7,500 $7,500
Credit to their capital dividend
account $52,500 $32,500 $85,000
The CRA’s view reflects a strict reading of the provision. The provision as drafted does not appear to contemplate possible business scenarios, particularly as it relates to multiple beneficiary situations. Consider the following examples of situations where the CRA’s view creates an unfair outcome.
Example One
A parent is the owner of Holdco, which in turn owns a life insurance policy and fixed value preferred shares of OpcoA and OpcoB. The common shares of OpcoA and OpcoB are owned by different children each with their own business plan. The life insurance owned by Holdco names OpcoA and OpcoB as beneficiaries of the policy.
The purpose of this arrangement is to fund a redemption of the preferred shares. By redeeming the preferred shares, each child gains independence from the family and the value of preferred shares in Holdco is converted to cash to support the other estate planning needs of the parent.
In this example, the children were active in the family-owned business and a transfer of ownership from the parent is a logical and valid business and succession plan. It is common and a reasonable strategy for family businesses to use life insurance to help fund succession costs.
Example Two
A business owner might use a Holdco above several Opcos in order to creditor protect the situation by not holding hard assets in the operating companies. If one of the operating companies should need financial support, the arrangement is that Holdco would provide that support. One such way to provide support is to name the Opcos as beneficiaries for a portion of life insurance owned by Holdco. In this type of structure, an insurance arrangement is commonly required under each of the Opcos borrowing arrangements with their lenders.
Example Three
Two partners in business may hold their shares of Opco in each of their holding companies. Their buy-sell arrangement might say that each partner is to buy life insurance on their life and hold it in their individual Holdco naming Opco as beneficiary for the amount necessary to fulfill the buy-sell arrangement. Each of the partners could decide to buy extra insurance for individual needs or to have sufficient coverage should the value of Opco rise over time. Each of the Holdcos would name Opco for a portion of the insurance proceeds and their respective Holdco for the excess.
Even though there are legitimate reasons for naming multiple corporations as beneficiaries of a single life insurance policy, a conscious review of these arrangements would be advisable in light of the CRA’s position on this issue.