By Farzin Remtulla, CPA,CA, TEP, CFP®, ZLC Financial Associate

In ZLC’s recent blog post titled Planning Tips to Consider During COVID-19, we suggested undertaking an estate freeze or a re-freeze of your corporate shareholdings. This can be a good time to act as the value of many businesses have been substantially reduced due to the economic crisis. Freezing at a lower valuation can reduce the future tax exposure of your estate.

I recently published an article for the CPABC In Focus Magazine on the transfer of wealth from one generation to the next. I focused on corporate owned life insurance as a proven and tax efficient strategy to fund the taxes payable by an estate. Life insurance financing takes the benefits of corporate owned life insurance a step further by leveraging the cash value of a policy to put money back into the corporation’s business activities. It is a means of obtaining insurance protection while preserving cash for operations.

More aggressive insurance financing structures have started to enter the marketplace as of late. Many of these muddle insurance financing with schemes that seek to strip corporate surplus at lower tax rates. Exercise caution when contemplating aggressive tax promoter schemes that are geared towards obtaining a preferential tax result rather than insurance protection. Such schemes can land you in hot water with the tax authorities. #successfulsuccession

The following article was originally published in CPABC In Focus Magazine, March/April 2020 Issue.

More than half of Canada’s seniors are baby boomers.¹ Many are well into their sixties, and with the wealth they’ve accumulated over their lifetimes, it’s expected that trillions of dollars will soon be passed to the next generation. Among those waiting in the wings of this great wealth transfer are governments and their tax authorities, many with their own versions of inheritance or estate taxes. While there is no estate tax in Canada, this does not mean that wealth can be transferred from one generation to the next without incurring tax.

At the time of death, Canadians are generally deemed to have disposed of and reacquired their assets at fair market value, and this deemed disposition has the effect of taxing accrued gains to prevent tax on these gains from being deferred indefinitely. For Canadian business owners, this often means that the wealth they accumulate within their corporations will lead to a hefty tax bill for their estates. Accordingly, they must consider how to fund the tax in the most efficient way possible.

A corporate-owned life insurance policy is one proven strategy to address the liquidity needs of an estate. Corporate-owned life insurance offers a number of benefits. In addition to providing instant liquidity to the estate, it allows:

• Tax-sheltered growth within the policy to the extent permitted by the exempt test in the Income Tax Act;
• Insurance proceeds to generally be paid out from the corporation on a tax-free basis through the capital dividend account; and
• Families to preserve assets and continue growing their legacies, rather than having to leverage assets or sell them at a discount to fund the tax bill of the estate.

Although they recognize the importance of planning for capital gains taxes, many in the boomer generation want to continue building their businesses well into their later years. For these business owners, the future benefits of a corporate-owned life insurance policy often end up competing with their more immediate need for liquidity. This is where insurance financing can be the right tool, as it can fulfil these competing needs.

• How insurance financing works
• What to consider
• Exercise caution when looking at tax promoter schemes
• Final thoughts

How insurance financing works

In its basic form, insurance financing involves funding a corporate-owned life insurance policy with a company’s existing assets. The corporation can then use the cash surrender value of the policy as collateral to borrow an amount up to that of the premiums paid. This can reduce the corporation’s annual insurance cost to the amount of interest paid on the borrowed funds, less any tax savings associated with deducting the interest charges and any tax savings associated with deducting a portion of the insurance premiums.²

When the insured individual dies, the policy’s death benefit will first be used to repay the outstanding loan and the residual insurance payout will be paid to the corporation. As for the capital dividend account, the corporation will receive a credit for the full amount of the death benefit, less the policy’s adjusted cost base, triggering a capital dividend addition that exceeds the net cash proceeds received.

What to consider

In the end, insurance financing can provide a tax-efficient and cost-effective way to fund an estate’s liquidity needs, but it’s not for everyone. Tax advisors may want to review the following questions with their business-owner clients to determine if this strategy is the right one for them:

• Does the corporation need the borrowed funds? If the corporation has excess or redundant cash, leveraging may not be an appropriate strategy.
• What is the intended use of the borrowed funds? Is it to earn income from investment or business, which is a general requirement for the interest to be tax deductible?
• Is the corporation comfortable taking on debt?
• If the corporation wants to borrow back the full amount of premiums paid, is the corporation okay with the possibility of having to post additional collateral in the early years, when a policy’s cash surrender value has not caught up to the premiums paid?
• Does the corporation have sufficient and sustainable taxable income to make use of the tax deductions that arise from the borrowing?

Exercise caution when looking at tax promoter schemes

Many new forms of insurance financing have started entering the marketplace, some of which muddle insurance financing with schemes that seek to strip corporate surplus. Asked to comment on aggressive tax structures that use insurance financing, the Canada Revenue Agency (CRA) said in 2018 that it would continue to monitor and address the situation, with particular attention to cases where the main purpose of the life insurance strategy is to seek preferential tax benefits.³ More recently, the CRA provided CPA Canada with a list of the tax promoter schemes it’s currently reviewing, one of which involves a complex strategy that uses life insurance to distribute corporate surplus.⁴

The CRA clearly has concerns with structures that use life insurance for the main purpose of obtaining tax gain rather than insurance protection. Listed below are some questions to ask when assessing the suitability and tax risk associated with tax promoter schemes that use life insurance:

• Is the main purpose of the strategy to obtain insurance protection to address an insurance need or is it to obtain a preferential tax result?
• Is there a legitimate business reason to leverage the life insurance policy and take out a bank loan?
• When presented with a split-dollar arrangement, is the amount paid by each party fair, given the benefits received?⁵
• Are the products that form the insurance arrangement heavily interdependent? For example, does the arrangement include products such as annuities or advisor loans that would not have been issued in the absence of the insurance arrangement?⁶ If so, this could be a red flag for the CRA, which could perceive the arrangement as a sham transaction or a transaction that is subject to the general anti-avoidance rule (GAAR).⁷

Final thoughts

When using insurance financing in estate planning, it is imperative not to get carried away. The simple rule to follow is that proper insurance planning should start from an insurance need and insurance financing should start from an investment need. And when it comes to minimizing the tax implications of the great transfer of wealth, corporate-owned life insurance is an essential tool in a tax planner’s toolkit.

¹ Statistics Canada, “Canada’s Population, July 1, 2019,” released September 30, 2019.
² See subsections 20(1)(c) and 20(1)(e.2) of the Income Tax Act.
³ 8 May 2018 CALU Roundtable Q. 7, 2018-0752971C6 – Golini v. The Queen.
⁴ Bruce Ball, FCPA, FCA, CFP, “Practitioners Beware: CRA Is Stepping Up Reviews of Tax Promoter Schemes,” CPA Canada, December 19, 2019.
⁵ Certain structures involve the co-ownership of a life insurance policy and its benefits between a corporation and its shareholder. This is commonly referred to in the insurance industry as a split-dollar arrangement. The CRA has said that a benefit under sections 15(1) or 6(1)(a) of the Income Tax Act can arise where a shareholder pays a premium that is less than the premium for comparable rights available in the marketplace under a separate policy. See 8 May 2012 Roundtable, 2012-0435661C6 – Shareholder Benefit – Co-Ownership Life Insurance.
⁶ See 8 May 2018 CALU Roundtable Q. 7, 2018-0752971C6 – Golini v. The Queen.
⁷ Ibid. The argument of GAAR was put forward by the Crown as an alternative position in Golini v. The Queen and accepted by the Tax Court of Canada.

Disclaimer: This information is designed to educate and inform you of strategies and products currently available. The views (including any recommendations) expressed in this commentary are those of the author alone and are not necessarily those of ZLC Financial. This information is not to be construed as investment advice. It is for educational or information purposes only. It is not intended to provide legal, taxation or account advice; as each situation is different, please seek advice based on your specific circumstance. This commentary is not in any respect to be construed as an offer to sell or the solicitation of an offer to buy any securities.

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