Mr. X holds the preferred shares of Opco with a redemption value of $1 million, and adjusted cost base and paid-up capital of $1, and a family trust holds the common shares. Opco owns a $1 million life insurance policy on the life of Mr. X with a cash surrender value of $500, adjusted cost basis (ACB) of $50,000 and fair market value $450,000. If the Policy is transferred to Mr. X as a dividend in kind on his preferred shares, what would be the proceeds of the disposition of the Policy to Opco, the income inclusion to Mr. X and the ACB of the Policy to Mr. X? CRA responded:
[P]aragraph 148(7)(a) would apply to deem the proceeds of the disposition to Opco to equal $50,000 (the greatest of CSV ($500), consideration (nil) and ACB ($50,000)), resulting in a policy gain of nil. Mr. X would be deemed to acquire the interest in the Policy at $50,000 pursuant to paragraph 148(7)(b). At the same time, subsection 82(1) would result in an income inclusion to Mr. X…[of] $450,000 plus a gross up… .
In cases where the FMV of the interest in the life insurance policy is greater than the ACB of that interest, subsection 148(7) provides for a transfer of the interest on a rollover basis (assuming that the consideration given for that interest and the CSV are equal to or less than the ACB). Notwithstanding that the shareholder will have an ACB in the policy that is less than FMV, it is not clear that this result is intended in terms of tax policy. We have brought this situation to the attention of the Department of Finance for their consideration.