By Enzo Morini, CPA, CA, TEP, Williams & Partners Chartered Professional Accountants LLP
Corporate owned life insurance on the life of an owner-manager can be an effective planning tool for Canadian- Controlled Private Corporations. The receipt of life insurance proceeds by a corporation can be used to: fund the buyout of a deceased shareholder’s interest; fund the tax liability owed by a deceased shareholder’s estate; or, offset the economic loss as a result of the death of a key employee. In addition, corporate owned life insurance may assist in securing bank financing.
As corporate income tax rates are significantly lower than personal tax rates, using corporate after tax dollars to pay for life insurance premiums is more favourable. Where the life insurance policy and coverage is a requirement imposed by a bank for financing, the premiums may also be deductible for income tax purposes to the extent of the amount borrowed relative to the amount of insurance coverage.
Changes to various tax rules with respect to life insurance have been under review for several years. In the 2012 Federal Budget, the Department of Finance indicated it would introduce legislation to modernize life insurance rules and these proposed rules were modified in Bill C-43 which received Royal Assent on December 16, 2014.
These new rules will be in effect on January 1, 2017 and for the most part will only apply to new policies issued. Policies issued prior to January 1, 2017 will be grandfathered provided no medical underwriting is added to the policies on or after January 1, 2017 or the policy is not converted into another type of policy.
Changes to the Capital Dividend Account Balances
The death benefit received by a corporation on the death of an insured less the adjusted cost basis (“ACB”) of the life insurance policy is added to a corporation’s Capital Dividend Account (“CDA”). The balance of the CDA can be paid out to a shareholder as a capital dividend which is received on a tax free basis by the shareholder.
The ACB of a policy is equal to the total premiums paid with respect to that policy less the total Net Cost of Pure Insurance (“NCPI”).
As a result of the increased life expectancy of Canadians, newly updated mortality tables will be used to calculate the NCPI resulting in lower NCPI rates and consequently higher ACB of policies going forward. As a result of the higher ACB of life insurance policies, the amount of life insurance proceeds received on the death of an insured that is added to the capital dividend account will be reduced. As always, in order for a shareholder to receive the proceeds of life insurance policies that are not added to the capital dividend account, the shareholder will have to receive a taxable dividend.
Life Exempt Test Rules
Life insurance provides protection but some policies also allow for the accumulation of savings on a tax deferred basis. This preferential treatment is available for certain “exempt” insurance policies. Under
the exempt test, provided the investment income accumulation in the policy does not exceed a defined amount, the investment income is not subject to annual accrual taxation.
Several changes to the exempt test will become effective on January 1, 2017. The exempt test changes will materially reduce the maximum accumulation amounts which can remain tax exempt within a policy. The exempt test compares the savings component of the actual life insurance policy to the savings component of a theoretical benchmark policy.
The key changes to the exempt test include:
- A revised definition of the benchmark policy;
- New prescribed assumptions with respect to calculating the savings element;
- New prescribed assumptions with respect to reserves;
- revisions to the rate at which death benefits can be increased; and
- revisions to the amount of funding required for policies.
The new life insurance rules will diminish some of the tax advantages available with life insurance products. However, corporate owned life insurance remains an effective tax and estate planning tool.
