Article DownloadFor many business owners who have seen their businesses flourish through years of hard work, one ongoing difficulty is how to unlock the wealth held captive in their corporation. One method of gaining access to some of those retained earnings in a tax-effective manner is through the sale of a personally owned life insurance policy to a non-arms-length corporation.
Where the individual shareholder owns a life insurance policy, either permanent or a term policy that is convertible to permanent, they may sell that policy to their corporation. As that transaction would be determined to be not at arms-length, Section 148(7) of the Income Tax Act will apply and the shareholder/policyholder will receive funds from the company equal to the fair market value of the policy. The amount by which the CSV of the policy exceeds the ACB would be taxed as income to the shareholder. The company’s adjusted cost base for the policy is not deemed to be the FMV, but rather, as directed by Section 148(9), the cash surrender value. This typically allows bulk of the death benefit to flow tax-free through the Capital Dividend Account upon the death of the insured.
Typically, life insurance is valued using a very simple methodology: term policies are held to have no value, and permanent policies are said to worth the CSV. However, where determining an accurate value is important, the fair market value is used. Canada Revenue Agency defines FMV in CRA Information Circular 89-3: “FMV is defined as the highest price obtainable in an open and unrestricted market between knowledgeable informed and prudent parties acting at arms-length, neither party being under any compulsion to transact.” A number of variables can give rise to a fair market value being considerably higher than the CSV, critically is the underlying health of the insured. If the individual has suffered a deterioration of health which would give rise to a rating or uninsurability, then the FMV will start to approach the death benefit. Other variables that can result in a higher FMV include conversion provisions or changes in the underlying pricing of the policy.
For example, a business owner has a permanent life insurance policy. The face value of the policy is $1,000,000. The CSV of the policy is $350,000 and the ACB (essentially the accumulation of all policy premiums paid over the years) is $275,000. Last year, he suffered a heart attack. Determining that he would like to remove some money from his business, he commissions a fair market valuation of his life insurance policy, given his new health status. After the medical data is reviewed, an actuary has determined that the FMV of the policy is $750,000. He transfers the policy to his corporation and takes out $500,000 in cash and a $250,000 promissory note. The company acquires the policy with a new ACB of $350,000 and the business owner pays tax on income of $75,000 (CSV-ACB).
There are some issues that a business owner should be aware of when holding a permanent life insurance policy inside a corporation. First, the policy is an asset of the corporation and exposed to creditors, so it does not enjoy the same level of creditor protection as many personally owned policies do. Second, the CSV of the policy is considered a passive asset of the corporation. Care should be taken that the policy does not impede the owner to use their capital gains exemption if they sell their corporation. Additionally, if the shares of the company are subsequently sold, the business owner will likely want to transfer the policy to personal ownership, with potential income tax consequences. All of these factors mean that holding companies tend to be more popular vehicles for holding life insurance policies than operating companies. Finally, any policy that is transferred to a corporation through a fair market valuation should be held to maturity.
There are several other situations where one may want to engage a fair market valuation of a life insurance policy. Many incorporated doctors, dentists, accountants, and lawyers own one or more life insurance policies and wish to transfer those policies to their corporation so that the payment of policy premiums can be made with corporate dollars, allowing for substantial increases in the accumulated value of those policies. The gifting of insurance policies to registered charities can make use of a fair market valuation to ensure that a tax receipt is issued for the maximum allowable amount. Additionally, corporate freezes, transfer of assets from an operating company to a holding or sister company, or the sale of a business where businesses own insurance policies, will all give rise to valuation requirements, as will a marriage breakdown.
