Life insurance gives a level of financial security for family
members of the deceased. However, having a policy also has
investment purposes or provides future liquidity. The decision as
to who should own life insurance (whether personally or
corporately) should be relevant to your circumstances. Over time,
these circumstances may change and there may be a desire to change
the holder of the policy.
In the absence of special rules, where a person (the transferor)
transfers an asset to another person or entity, he/she is generally
considered to have received fair market value (FMV) consideration
in exchange for the asset. Thus, he/she will incur an income tax
liability to the extent that the FMV exceeds the tax cost (value)
of the asset to the transferor.
The rules surrounding the income tax treatment of life insurance
are complex, and one such special rule currently applies to the
transfer of life insurance between non-arm's length persons.
Specifically, a transfer of a life insurance policy is
considered to take place for proceeds equal to the cash surrender
value (CSV) of the policy and not at the FMV of the
In contrast to the FMV, the CSV represents the amount that the
life insurer would pay if the policyholder were to cancel his/her
policy before its maturity. The FMV may be substantially higher
than the CSV if, for example, the insured has health problems that
have resulted in a reduced life expectancy. Where this is the case,
there may be an opportunity to extract tax-free corporate
Consider the following example. Let's assume that Mr. Smith
personally holds a life insurance policy that he has held for many
years. Mr. Smith is in poor health. Let's assume that the cost
of the policy is zero, the CSV is zero, but the FMV is $1 million
because of Mr. Smith's reduced life expectancy.
Mr. Smith transfers the policy to his wholly owned corporation
(SmithCo) in exchange for a demand promissory note of $1 million.
Although Mr. Smith has received FMV consideration, he is deemed to
dispose of the policy for no proceeds (i.e. at CSV) for income tax
purposes. Consequently, since the proceeds of disposition in
respect of the transferred policy are equal to the cost of the
policy to Mr. Smith, no income tax will result on the transfer. At
the same time, SmithCo may immediately repay the promissory note to
Mr. Smith without any further income tax implications.
When Mr. Smith passes away, SmithCo will receive life insurance
proceeds (on a tax-free basis) of $1 million. These funds will be
added to SmithCo's capital dividend account (CDA), which is a
notional account from which funds can be distributed to
shareholders in a tax-free manner.
Because of this planning, Mr. Smith is able to both receive the
life insurance proceeds on a tax-free basis (by way of the CDA)
and extract $1 million cash from his company (by way of
repayment of the promissory note) on a tax-free basis.
Mr. Smith was able to derive a tax benefit to the full FMV of
the policy, but this may not always be the case. When the FMV of
the life insurance policy exceeds its CSV, a similar set up will
generally yield an income tax benefit. In summary, you can realize
the greatest income tax benefits when the FMV is significantly
higher than the CSV. In Mr. Smith's case, the CSV was nil
resulting in the extent of the benefit being fully maximized.
The rules surrounding the tax treatment of life insurance are
complex and the facts pertaining to a particular situation must be
carefully and holistically considered to ensure that negative tax
(or other) consequences are adequately considered. For example,
there may be a loss of creditor protection by having the life
insurance policy in the corporation, and/or a loss of a
shareholder's ability to claim the lifetime capital gains
exemption in respect of the shares of the corporation. In the right
situation, however, careful planning may result in significant tax
The life insurance taxation system has recently been under
heightened scrutiny by the Department of Finance and several
changes to the taxation of life insurance products have already
been enacted. It is possible that the rules allowing this
particular tax benefit will change in the future. Consequently, if
you personally hold a life insurance policy with a high FMV and
lower CSV, immediate consideration of this planning opportunity is
As always, each situation is different, we recommend consulting
with your Crowe Soberman professional advisor and your life
This article was prepared by Marissa Verskin who is a senior
manager in Crowe Soberman's Tax Group.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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