ESTATE DILEMMAS
BY KEVIN WARK
CDA Basics Tips and traps of a corporation’s capital dividend account
A
private corporation may acquire life insurance on the life of a shareholder for a number of business purposes, such as collateral insurance for corporate debt, to fund a buy-sell agreement, or to provide liquidity to a shareholder’s estate. It is often assumed that all or most of the life insurance proceeds will be credited to the corporation’s capital dividend account (CDA). However, recent tax changes and interpretations may reduce what is actually credited to the CDA and available for distribution as a tax-free capital dividend. Let’s review several of these changes and provide some helpful planning ideas and tips. Essentially, the credit to a corporation’s CDA is equal to the insurance death benefit less the adjusted cost basis (ACB) of the policy. For example, if a corporation receives a $500,000 death benefit and the ACB of the policy is $50,000, the credit to the CDA will be $450,000. This amount can be distributed to shareholders as a taxfree capital dividend. While many factors can influence a policy’s ACB, in many cases it will be equal to the cumulative premiums paid, less the cumulative annual “net cost of pure insurance” (NCPI) charges for the policy. The NCPI is a notional annual mortality cost associated with the policy as determined under the Income Tax Act. For a level cost insurance policy, the ACB generally increases in the early years as premiums will exceed the NCPI charges, and will decrease in later years as the NCPI charges grow larger. As a result, the ACB of a policy typically declines to zero as the insured reaches life expectancy.
2017 TAX CHANGES In 2017, significant changes were made to the life insurance tax rules that govern policies issued after 2016. One impact is a 26 FORUM NOVEMBER / DECEMBER 2019
general reduction in the annual NCPI charge for any given policy. Thus, for policies issued after 2016, the ACB will generally be higher and remain positive for a longer period of time, which could result in a lower credit to the CDA. However, the impact of this change can vary depending on the type of policy, the premium payment pattern, and the type of mortality costs deducted under the policy. Thus, through careful product design it may be possible to “manage” the ACB of a policy issued after 2016 to maximize the credit to the CDA. These rule changes don’t apply to policies issued before 2017. But it is possible for a pre-2017 policy to lose its “grandfathering” due to a policy change, such as increasing the insurance coverage. If this happens, the policy will become subject to the new NCPI calculation. Caution should therefore be exercised in making changes to a pre-2017 corporate owned policy as it could negatively impact the CDA credit.
MULTI-BENEFICIARY POLICIES Certain changes were made in budget 2016 to prevent the “stripping out” of a policy’s ACB by having a different corporate owner and corporate beneficiary. These changes will apply to policies in force prior to the budget, and thus the CDA may be lower than expected. This change may also result in the ACB of the policy being “double counted.” For example, assume Holdco owns a policy on the life of its shareholder (Ms. A) with a death benefit of $1 million and an ACB of $100,000. If Holdco was the beneficiary of the policy, the CDA credit on the death of Ms. A would be $900,000. Now let’s assume Opco, which is wholly owned by Holdco, requires $500,000 of insurance on Ms. A’s life. Rather than purchase a new policy, Holdco could designate Opco
as beneficiary for $500,000. On Ms. A’s death, Holdco and Opco will each receive $500,000 of insurance proceeds. However, the ACB of $100,000 will used in determining the CDA credit of both companies, resulting in an aggregate CDA of $800,000, exposing an additional $100,000 to tax on distribution. It might be advisable to have just one corporate beneficiary under the policy to avoid this issue.
MULTI-LIFE POLICIES Corporate owned multi-life policies issued before 2017 suffer from a similar “double counting” issue, as the ACB associated with all coverages will be taken into account in determining the CDA credit on the death of each life insured. Consideration might be given to separating the coverages into different policies to avoid this result. However, there may be administrative restrictions or adverse tax implications that prevent this. The situation for multi-life policies issued after 2016 is somewhat better, as there is now a mechanism to adjust the ACB of the policy after the payment of a death benefit under a coverage.
POLICY TRANSFERS Prior to budget 2016 there were tax advantages that might arise where a shareholder transfers a personal insurance policy to a private corporation at its fair market value. These tax advantages no longer exist for transfers made after March 21, 2016. As well, any tax benefits arising from a policy transfer made after 1999 and before March 22, 2016 will reduce the CDA credit available to the corporation on the death of the life insured. Unfortunately, there is very little that can be done to avoid this result. The rules for determining the CDA credit from corporate owned insurance have recently become more complex, and careful planning is required. Advisors looking for more detailed information on these rules can refer to Tax Folio S3-F2-C1 (Capital Dividends). KEVIN WARK, LLB, CLU, TEP, is the author of The Essential Canadian Guide to Estate Planning (2nd Ed.) and The Essential Canadian Guide to Income Splitting.