R.A. Primeau (613) 957-2122
June 10, 1987
Dear Sir:
Re: Capital Dividend Account ----------------------------
This is in reply to your letter of March 30, 1987.
You have outlined a situation in which a partnership, all of the partners of which are corporations, owns and is the beneficiary of insurance policies on the lives of each of the corporate partners' respective principal shareholder. On the death of the principal shareholder of a particular corporate partner, the partnership receives the insurance proceeds from the policy on his life and allocates them all to his corporation in accordance with the terms of the partnership agreement. You further indicate that these insurance proceeds are then used to acquire the partnership capital account of the deceased shareholder's corporation and to pay off any other obligations of the partnership to that corporation.
You have asked our opinion on whether, in the above situation, the full amount of the insurance proceeds so allocated to the corporate partner whose principal shareholder has died would be added, by virtue of subparagraph 53(1)(e)(iii) of the Income Tax Act (the "Act"), to the adjusted cost base ("ACB") to such corporate partner of its interest in the partnership and whether the full amount of such insurance proceeds would also be added to the capital dividend account of such corporate partner by virtue of subparagraph 89(1)(b)(iv) of the Act.
Both of subparagraphs 53(1)(e)(iii) and 89(1)(b)(iv) of the Act provide for the income tax treatment of the realized gain on a life insurance policy resulting from the death of the insured, that is, the excess of the proceeds from the policy over the ACB of the policy to the owner thereof immediately prior to the insured's death. In the situation you have outlined, if the full amount of the proceeds from a policy are allocated by the partnership, under the terms of the partnership agreement, to the deceased shareholder's corporation, and if the fair market value of the corporation's interest in the partnership goes up accordingly to reflect this allocation, then the full amount of the realized insurance gain would be added to the ACB to the corporation of its interest in the partnership by virtue of subparagraph 53(1)(e)(iii) of the Act. Also, the full amount of such realized insurance gain so allocated to the corporation would be added to the corporation's capital dividend account by virtue of subparagraph 89(1)(b)(iv) of the Act. We should point out, however, that the allocation of the full amount of the insurance proceeds to the corporate partner whose principal shareholder has died renders it impossible for such insurance proceeds to be sufficient to acquire the partnership interest of such corporate partner. A portion of such acquisition cost will therefore have to come from the partnership itself.
To illustrate this problem with a simple example, assume the following situation:
1) A partnership has three corporate partners, A Co., B Co. and C Co. Except for life insurance proceeds, the partnership allocates all profits, gains and losses equally to the corporate partners.
2) The sole shareholders of A Co., B Co. and C Co. are Mr. A, Mr. B and Mr. C, respectively.
3) The balance of the partnership capital accounts of A Co., B Co. and C Co. are each $50,000, as are the respective fair market values of each partner's interest in the partnership (in a real situation, a partner's capital account balance may not be the same as the fair market value of his interest in the partnership).
4) The partnership is the owner and beneficiary of term insurance policies on the lives of each of Mr. A, Mr. B and Mr. C. The coverage on each of the policies is $50,000.
5) Mr. A dies and the partnership receives $50,000 proceeds from the policy on his life.
6) Immediately prior to Mr. A's death, the ACB to the partnership of each of the three policies is $5,000, consisting solely of the premiums to date on these policies, the $15,000 total of which has been allocated equally among the three corporate partners and reflected in their respective $50,000 partnership capital accounts. Since these insurance premiums are not deductible expenses, the ACB to each corporate partner of its interest in the partnership is $55,000, not $50,000.
In the above situation, if all of the $50,000 proceeds of the policy are allocated by the partnership, in accordance with the terms of the partnership agreement, to A Co., then A Co.'s partnership capital account would be increased by $50,000, that is, from $50,000 to $100,000. For tax purposes, assuming that the fair market value of A Co.'s interest in the partnership also increases from $50,000 to $100,000 as a result of this allocation of the life insurance proceeds, the ACB to A Co. of its interest in the partnership would be increased by the $45,000 realized life insurance gain, that is, from $55,000 to $100,000. A Co.'s capital dividend account would also be increased by the $45,000 realized life insurance gain allocated to it. The final result would therefore be that A Co. would receive from the partnership $100,000 for its interest in the partnership, which would essentially be a payment of the $50,000 fair market value of such partnership interest (and balance in A Co.'s partnership capital account) immediately prior to A's death plus the $50,000 life insurance proceeds. There will be no capital gain to A Co. due to the $100,000 ACB to it of its interest in the partnership, and A Co. could distribute $45,000 tax free as a subsection 83(2) capital dividend. However, there would be only $100,000 remaining in the partnership after A Co. has been paid the $100,000 proceeds for its partnership interest. This does not achieve the objective of having the $50,000 insurance proceeds received on the death of A being used to buy out the fair market value of A Co.'s partnership interest (balance in A Co.'s partnership capital account) as at the point in time immediately prior to A's death so that the $150,000 in the partnership prior to the death of A will remain intact in the partnership.
We hope that our comments will be of assistance to you.
Yours truly,
for Director Reorganizations and Non-Resident Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch