Don’t Take CDA For Granted

Employees Beware! I recently saw the film by Michael Moore entitled “Capitalism: A Love Story”. In it was a pretty gruesome segment about how some large corporations like Walmart take out life insurance on their employees, essentially placing “bets” on their lives, and cashing in on their deaths, with all of the insurance proceeds going to their bottom lines, and nothing to the families of their employees. Pretty cold.

I can’t really comment on whether that story was embellished or slanted in any way, but I can comment on a Canadian case that recently caught my eye, and it’s a cautionary tale about proper planning and not taking anything for granted.

Mr. A entered into an employment agreement, whereby life insurance was taken out on him by his employer. Mr. A was also a shareholder of the company, and in the case of his death, the insurance proceeds would be used to purchase his shares. The agreement did not go any further.

Life insurance proceeds are tax-free to the beneficiary. In this case, the beneficiary was the company. In many cases, the tax-free nature of the life insurance is passed on to benefit the deceased’s estate through the use of a capital dividend (CDA) election. If not, the repurchase of shares by a company are taxable.

A CDA election is a choice that is made by the company, who is not legally required to make it, unless obliged to do so by contract.

In the case of Mr. A, the CDA benefit was not passed on to him, costing his estate to be liable for $250,000 in taxes. It may be that in this case, the intent was never to use the CDA for the share repurchase. In my experience, though, the omission is usually an oversight. The question of using the CDA to repurchase shares must always be addressed and resolved at the time the agreement is drafted.

The CDA was used by the remaining shareholders of the company which I’m guessing turned out to be a windfall for them. Mr. A’s estate attempted to sue for damages, but again, without a clearly defined obligation in the shareholders’ agreement, the company was not held responsible for the deceased’s tax liability.

What’s the moral of this story? Well, I can’t really comment on the character of the parties involved in this case (I’m sure they all have some good in them), but I can say this: Never sign a shareholder’s agreement without the help of a tax professional!

Life insurance and Shareholder Benefits

Corporate-owned life insurance is always a hot topic. Generally, a corporation will be the owner and beneficiary of a policy. The proceeds received on death are tax-free to the corporation. However, a whole life policy is also an investment vehicle which has an adjusted cost base (“ACB”) for tax purposes. Only the excess of the proceeds over the ACB of the policy can be distributed to the shareholders on a tax-free basis via the Capital Dividend Account (“CDA”). For this reason, it is often recommended that the beneficiary be separated from the corporate owner so that the full amount of the proceeds can be received tax-free.

If the beneficiary is different from the corporate owner, questions arise as to whether a benefit is being conferred by the corporation. If the beneficiary is an individual shareholder, the CRA has stated that a taxable benefit will arise.

During the 2009 Canadian Tax Foundation Conference, the CRA announced a change in its policy regarding the holding of life insurance by a corporation with a holding company as the beneficiary.

The CRA was asked for its view on the application of subsection 15(1) (shareholder benefit) in the following situation: A, an individual, wholly owns Parentco, which in turn wholly owns Subco. Subco has a life insurance policy on the life of A and pays the policy premiums. The beneficiary of the policy is Parentco. This strategy is often useful because the full amount of the insurance proceeds in this structure gets added to the CDA account of Parentco and is not reduced by the policy’s ACB.

In previous policy statements, the CRA stated that the shareholder benefit provisions would not operate in these circumstances to include a benefit in the income of Parentco.

However, the CRA has announced a change to this administrative position. In a situation such as the one described above, the CRA now considers that subsection 15(1) will operate to include a benefit in the income of Parentco as a consequence of Subco paying the policy premiums. This benefit would be income from property.

The CRA stated that this change in its position is to be applied prospectively for new policies issued in 2010 and later. For policies already issued, the amount of the benefit incurred will be included in the shareholder’s income as of the 2011 calendar year. The CRA also noted that the General Anti-Avoidance Rule could apply to reduce the amount of Parentco’s CDA upon receipt of the proceeds of the life insurance policy unless there was a bona fide reason for the insurance holdings.