Demutualization:
Income Tax Concepts and Planning

By Jillian Welch and Steven Baum, McCarthy Tetrault, Toronto, and Ted Ballantyne, CALU

In December 1998, a CALU Special Report was issued which outlined the demutualization process. In this Special Report, the income tax Aspects of demutalization benefits in a number of situations are discussed. It is not possible to illustrate all possible situations and members are encouraged to advise their clients to seek professional advice to address each client's particular situation.

Finance Minister Paul Martin released the draft legislation on the tax consequences of demutualization on Dec. 15, 1998. As anticipated, the draft legislation was consistent with the description of how demutualization benefits were to be taxed that was set out in the government's Aug. 27, 1998, press release. The key features of the draft tax legislation are:

• Policyholders that receive shares will not have any immediate tax consequences.
• When the policyholder sells his or her shares (other than by way of redemption by the demutualizing insurance company) generally speaking there will be a capital gain equal to the sale price less any costs of disposition, as the cost of the shares to the policyholder will be deemed to be nil.
• If a policyholder receives a non-share demutualization benefit of any kind (including cash), then there will be immediate tax consequences to the policyholder as the value of such benefit will be taxed as a dividend. This deemed dividend is eligible for the dividend tax credit and gross-up mechanisms.

The following is a more detailed review of these basic tax principles and of the issues and potential tax planning opportunities that arise in certain situations. Many of the tax planning opportunities relate to the ability of policyholders to choose between different forms of demutualization benefits. For example, policyholders may be able to choose between shares of the demutualizing company, a cash payment and perhaps policy enhancements. A demutualizing company may also issue shares but then provide a redemption option so that policyholders receiving shares can sell them back to the company for a cash amount. Generally, such cash amount will be taxed as a dividend and its treatment will be similar to that of a cash payment. While the demutualizing companies may offer policyholders a choice between types of benefits, it is not clear at this time whether and to what extent choices will be available to a particular policyholder of any particular company.

Amendments to the Insurance Companies Act (Canada) and the Regulations, which will govern demutualization, will require that the demutualization benefits that will be provided to policyholders must be set out in each demutualizing company's "conversion proposal."

Finally, there may be legal restrictions that preclude certain policyholders (e.g., minors, certain non-residents and government entities) from receiving or owning shares of the demutualizing company. Such policyholders may have more limited choices of demutualization benefits as a result. Again, it is anticipated that each company in implementing its demutualization will address these restrictions.

1. Provincial tax rate for 1999 is assumed to be 40.5% of basic federal tax
2. Net tax does not include federal and provincial surtaxes.

Issues and Opportunities for Individual Policyholders

There are a number of planning considerations for individual policyholders. Five specific issues are addressed here, but since this article is not intended to be exhaustive, policyholders should discuss other alternatives with their advisors.

Individual policyholders: should they choose cash or shares?

A good starting point is determining whether a policyholder is better off electing to receive shares of the demutualized company or taking a taxable demutualization benefit such as a cash payment. As a general proposition, under the proposed tax rules, it is possible to defer any tax for as long as the policyholder continues to hold the shares, since no tax is payable on the receipt of the shares.

Accordingly, if the policyholder is content to remain invested in shares of the demutualized company then he or she ought to elect to receive shares.

If the policyholder does not intend to hold the shares, however, then the chart at the left illustrates that, absent an available capital loss that can be used to offset the capital gain arising on the disposition of shares, it is always better to receive a cash payment 3. This is because the federal "gross-up" and dividend tax credit mechanism yields an effective marginal rate of tax that is lower than the effective marginal rate of tax on capital gains.

3. Generally, references to a cash payment can be read to include a cash payment arising on a redemption of shares by the demutualizing company, which will also be treated as a dividend.

Regardless of a policyholder's income level and tax bracket, it is better to receive the benefit in the form of cash unless the policyholder has an available capital loss or the policyholder intends to sell the shares in the year received.

An individual policyholder is entitled to a conversion benefit and the policyholder has RRSP contribution room available.

As previously noted, shares received on demutualization have an adjusted cost base of zero and so any sale of the shares will result in all of the proceeds (less any costs incurred to sell the shares such as commission) being treated as a capital gain for the individual 4. If a policyholder has a self-directed RRSP with contribution room, the shares may he transferred to the plan, but the transfer will be considered a disposition for tax purposes. Three-quarters of the capital gain will be required to be included in the policyholder's income in the year in which the shares are transferred to his or her RRSP. The policyholder will, however, receive an RRSP deduction for the full market value of the shares contributed to the RRSP. The result would be the same if the policyholder elected to receive shares but then sold the shares and used the proceeds from the sale to make an RRSP contribution. Alternately, the policyholder could also elect to receive the benefit as cash and to contribute the amount received to his or her RRSP.

4. References to a sale of shares throughout this article are to sale other than by way of redemption by the demutualizing company. As noted above, a sale to the company, or redemption, will give rise to a deemed dividend in the year of sale and not a capital gain.

3 Combined rates assume a provincial rate of 40.5% of basic federal tax and do not include any federal or provincial surtaxes.
4 $5,000 contribution multiplied by the marginal tax rate.

In each case, as illustrated in the chart at the right, all of the current tax is effectively eliminated by the RRSP deduction. Unless the policyholder wishes to have his or her RRSP continue to hold the shares, it is more tax effective for him or her to receive the cash payment and use that as a source of funds for the RRSP contribution.

A parent owns a life insurance policy on a child and receives a conversion benefit as a result.

Where the parent was the owner of a life insurance policy on his or her child's life at the date the insurer announced its intention to demutualize and otherwise meets the requirements to be an "eligible policyholder," the parent is entitled to receive a conversion benefit, even though the child's life is insured. If the parent receives shares, the parent can continue to hold them and will pay capital gains tax on the eventual proceeds of disposition when the shares are sold, or upon their deemed disposition when the parent dies. The parent may wish to gift the shares to the child or to a trust established for the benefit of the child. In this case the parent will have a disposition for tax purposes, but any future growth will accrue to the child, who is usually in a lower tax bracket. However, income from the shares in the form of dividends will be attributed to the parent until the child ceases to be a minor. If the parent chooses to receive a taxable conversion benefit that will he taxed as a deemed dividend such as cash, the cash could still be gifted to the child. But, again, investment income subsequently earned on such cash will be attributed back to the parent until the child ceases to he a minor. Generally, the choice as to whether the receipt of cash or shares would be more tax effective will be dependent on the tax status of the parent.

Conversion benefits and the Guaranteed Income Supplement (GIS)

Individual policyholders who are eligible to receive conversion benefits should consider what effect, if any, the receipt of such a benefit (either in cash or in shares) will have on income- or means-tested government programs, such as the Child Tax Benefit, as well as other benefits they receive.

It should be noted, however, that the federal government has at least partially addressed the particularly egregious effect that the receipt of non-share conversion benefits could have for those policyholders receiving the GIS. Under the governing legislation, for $1 increase in income the GIS an individual receives is reduced by 50 cents. (The GIS is available to low- income individuals only. For example, for a single person over age 65, it disappears when income reaches a level of $11,736, excluding OAS and for a married couple both over age 65, when income exceeds $15,312, excluding OAS.) As dividends, including deemed dividends, received by individuals from Canadian corporations are subject to the dividend gross-up and tax credit mechanism, this means that the individual actually includes in his or her income for tax purposes the grossed-up amount of the dividend which is 125% of the actual amount of the dividend. For individuals who do not have sufficient income to fully use the dividend tax credit, the rules now provide for a reduction in the amount of dividend income so that these individuals are not penalized.

5 Assumes that the individual has $200 in other charitable donations.

A policyholder wishes to use the conversion benefit to make a charitable donation.

In this situation, the question is whether the policyholder is better off from a tax perspective receiving shares on the demutualization and gifting the shares to a charity or receiving a cash benefit on demutualization and donating the cash to the charity. As a further alternative, the policyholder could receive the shares, sell them in the open market and then donate the proceeds to charity. If the shares are donated to a charity before 2002, special tax rules previously announced will result in the taxpayer's taxable capital gain being 37.5% instead of the normal 75% of any capital gain. The tax comparison is illustrated in the above chart.

As may be seen, in virtually all cases it is better for the policyholder to receive the shares and donate those to the charity rather than to take the conversion benefit as cash and then donate the cash, or to take the shares, sell them and donate the cash proceeds. This is because the tax laws currently, but only until 2002, provide a particularly generous tax break to the policyholder with respect to the capital gain arising on the gift of the shares to the charity.

A completely different approach to the donation of conversion benefits may be of interest to policyholders who are unable to use the charitable donation tax credit but do have an interest in minimizing the effect of demutualization benefits on government benefits the policyholder receives. The policyholder can donate shares to a charity and elect to have his or her proceeds equal to the cost base of the shares, which is zero. As a result no amount would be required to be included in the policyholder's income.

Issues and Opportunities for Corporate Policyholders

A Canadian controlled private corporation owns a life insurance policy on one or more of its shareholders or employees.

One issue that could arise for this type of policyholder is whether the conversion benefit, if taken as shares or cash, will affect the status of the corporation's shares as "qualified small business corporation shares"8. This definition is important for determining the eligibility of the shares for the $500,000 capital gains exemption. This may be an important factor to consider if the shareholders have not yet crystallized the capital gains exemption as it relates to the increase in value of the corporation's shares and the company has a significant amount of other investment assets. Even if the conversion benefit taken alone would not disqualify the shares as "qualified small business corporation shares," the addition of the amount of the benefit may be sufficient to put the corporation's shares offside.

8. As defined in subsection 110.6(1)

If the corporation elects to receive the shares, then when the shares are sold the non-taxable portion of the capital gain would be a credit to the capital dividend account and generally could then be flowed out as a tax-free capital dividend to shareholders. If the acceptance of shares, however, will affect the ability of the shareholders to access the capital gains exemption, then the corporation should consider one of the other forms of conversion benefits available, including either an enhancement of benefits or premium reduction. While these are treated as a deemed dividend, they do not directly impact the company's investment portfolio.

If the private corporation chooses to receive a non-share conversion benefit such as cash or a policy enhancement, it will be treated as a dividend for income tax purposes. In this case, while it will generally be deductible in computing taxable income, it will be subject to tax under Part IV of the Act. This tax is refundable when the dividend is flowed out as a taxable dividend to the shareholders.

A trust governed by a retirement compensation arrangement (RCA) owns a life insurance policy and receives either shares or cash.

If an RCA trust owns a life insurance policy then the tax consequences arising on the receipt of the conversion benefit by the trust on demutualization will depend on the form of benefit received. If shares are received there should not be any immediate tax consequences to the RCA trust, although a 50% refundable tax will be eligible when the RCA trust disposes of the shares. If the RCA trust receives a benefit in the form of cash, or enhanced policy benefits, then it will have a refundable tax liability in respect of the deemed dividend. An interesting scenario is one where the life insurance policy itself has been deemed to be an RCA under the rules of the Act. In this event the policyholder, typically an employer, will receive the demutualization benefits and be taxed accordingly. Whether the policy covers a single executive or a group of employees, the employer will face the same issues as those of employers and other sponsors of group plans, as discussed below.

Issues and Opportunities for Group Policyholders

As discussed in the December 1998 CALU Special Report, the Nov. 30, 1998, draft insurance legislation requires that demutualization benefits be paid to "eligible policyholders," namely, policyholders who held their policies on certain specified dates. In the case of group insurance policies, the policyholder is typically the employer or other group sponsor, and so it is this policyholder that will receive the demutualization benefits and will bear the tax, if any, in respect of the demutualization benefits received. Each employer or group sponsor will need to consider, based on the circumstances surrounding the group policy and the terms of the policy and those of any governing plan text, whether group members insured under the policy have any entitlement to the economic benefit of any property received by the policyholder on demutualization. If a sponsor is going to "pass on" the demutualization benefits they receive to group members, consideration will need to be given to the form of demutualization benefit to be received and how that benefit is to be passed on in order to ensure this is done as tax efficiently as possible.

For example, where a group policy is held by an employer sponsor that is a public company, it may wish to choose to receive demutualization benefits in the form of a cash payment or policy enhancements so that it is deemed to receive a dividend in respect of which the inter-corporate dividend deduction should be available. A cash payment received could then be paid out to group members as an employee benefit, providing the employer with a possible deduction in computing its income, since the amount of the benefit would he required to be included by the employees in their income as a taxable benefit or remuneration.

The issue of entitlement to conversion benefits as between group members and group sponsors may arise where the sponsor, as policyholder, holds the particular group policy. This is not always the case - group insurance policies are often issued to trusts established by an employer, either as health and welfare trusts, employee benefit plans or any variety of registered vehicles such as registered pension plans or retirement compensation arrangements. In this event, the policyholder will generally be the trustee of the particular employee trust. As a result, it would be the trustee who is entitled to receive the demutualization benefits in its capacity as trustee and, accordingly, the demutualization benefits will accrue to the benefit to the employees who are beneficiaries of the trust, in accordance with its terms.

Another important feature of the draft tax legislation specifically addresses the situation where the employer is the sponsor of an "employee-pay-all" plan funded through a group insurance policy. Normally, the contribution by an employer of any amount to the plan results in the "tainting" of the plan so that benefits paid out become taxable to employees. The draft tax legislation provides that if the group sponsor receives demutualization benefits because of its status as policyholder of a group insurance policy under which employees are insured, the policy is an "employee-pay-all" plan, the employer contributes all or part of the benefit received into the plan and it is reasonable to conclude that the policyholder intended to apply that property for the benefit for the insured employees, then the premium paid by the employer into the plan is deemed to have been paid instead by the insured employees. As a result, periodic disability payments subsequently paid out of the plan to employees will not be considered taxable benefits and will continue to be received tax-free by employees.

Issues and Opportunities for Non-Residents of Canada

The options available to non-residents may vary from one demutualizing company to another, and indeed, may vary from one tax jurisdiction to another. Therefore the discussion in this section is generic, and addresses only Canadian income tax issues; not securities law or other issues that may determine what benefits in fact can be offered to policyholders in a particular jurisdiction.

On conversion, if a non-resident policyholder can accept shares, then the receipt of the shares and/or their disposition may be subject to tax in his or her home jurisdiction. However, for Canadian tax purposes, if shares are available to the non-resident, then no tax will be payable in Canada on their receipt and, provided the shares are listed on a "prescribed" stock exchange such as the TSE at the time of their sale, no Canadian tax will be eligible. Further, there is no current Canadian requirement for a non-resident to report the gain on a disposition of the shares, again provided that they are listed.

If the non-resident receives cash instead of shares, a deemed dividend will arise and will he subject to withholding tax of 25% on the gross amount of the dividend, unless the policyholder is resident in a country with which Canada has a tax treaty that provides for a reduced rate of withholding tax. 9

9. If the policyholder is resident in the U.S. or U.K., withholding would be reduced to 15% in accordance with Article X of the Canada-U.S. Tax Convention (1980) and the Canada-U.K income Tax Convention (1 978), respectively.

If the non-resident elected to receive a policy enhancement, or a decrease in premium, this would also be viewed as a deemed dividend. AS no actual payment would be made to the nonresident, it is unclear how the withholding tax obligation would be met. It is possible, for example, that only the net amount of the deemed dividend (the deemed dividend less the appropriate amount of withholding tax) would be applied to the policy enhancement or premium reduction and the balance considered to be paid in cash and remitted to Revenue Canada,

Summary

The foregoing is a brief discussion of some of the tax concepts and planning opportunities that may present themselves to policyholders on demutualization. The choices policyholders will have will vary from company to company - not all companies may offer all policyholders all of the options discussed in this article. Where non-residents are concerned, the conversion benefits offered may be restricted due to the effects of other governing legislation, such as the securities law in that particular country. Therefore, perhaps the best advice that members may give their clients is to seek professional advice that is relevant to their particular situation in order to ensure that the conversion benefit they elect to receive is the most tax effective in their particular situation.

This special report is published by the Conference for Advanced Life Underwriting as an informational service to members and is not intended to substitute for competent professional advice. No action should be initiated without consulting your professional advisors. © Conference for Advanced Life Underwriting. All rights reserved. No part of this publication may be reproduced in any form without Prior written permission.