Principal Issues: (1) Whether subsection 106(3) takes precedence over subsection 148(7) where a discretionary trust transfers an interest in a life insurance policy to its corporate beneficiary as payment of a dividend in kind received by the trust? (2) Whether a corporate beneficiary receiving an interest in a life insurance policy from a trust as payment of a dividend in kind received by the trust should be considered as having given a consideration for the interest in the life insurance policy? (3) Whether subsection 107(2) would be applicable if the dividend is paid by the trust by the issuance of a promissory note, which would be settled in kind the following year by the transfer of the life insurance policy to the corporate beneficiary?
Position: (1) None. General comments provided. (2) Yes. (3) No.
Reasons: (1) and (2) There will be a disposition of all or part of the beneficiary’s income interest in favor of the trust when the trust distributes the life insurance policy to its beneficiary in satisfaction of all or part of the beneficiary’s income interest. Determining the FMV of an income interest in a trust at any given time is a question of fact. To the extent that it is determined that at the time of disposition of the life insurance policy, the beneficiary’s income interest under the trust would include the right to enforce payment of an amount by the trust equal to the FMV of the life insurance policy, it could be argued that the consideration given by the beneficiary to the trust for the interest is equal to the FMV of that life insurance policy. In this context, the tax consequences that would arise from the disposition of the policy would be the same whether subsection 106(3) or 148(7) applies. Since it is not clear that such a result is consistent with tax policy, we will bring this issue to the attention of the Department of Finance. (3) A payment in kind to settle a promissory note is not a situation where a distribution of property from a trust is resulting in a disposition of all or part of the beneficiary’s interest in the capital of the trust. This is rather a situation where a debtor repays its debt to its creditor. The transfer of the life insurance policy by the trust in favor of its beneficiary in repayment of the promissory note gives rise to the application of subsection 148(7). The consideration given by the beneficiary to the trust for purposes of clause 148(7)(a)(ii)(B) corresponds to the amount of the debt being settled.
FINANCIAL STRATEGIES AND FINANCIAL INSTRUMENTS ROUNDTABLE, 3 NOVEMBER 2023
2023 APFF CONFERENCE
4. Transfer of a life insurance policy between connected corporations through a trust
Particular Situation
- Aco is the holder and beneficiary of a life insurance policy, for which it pays the premiums, on the life of its controlling shareholder, Mr. X (the "Policy"). The Policy is an insurance contract payable on the death of Mr. X that was purchased a number of years ago for the purposes of the shareholders' agreement.
- The Policy has a fair market value ("FMV") of $250, a cash surrender value ("CSV") of $150 and an adjusted cost basis ("ACB") of $50. The ACB, CSV and FMV of the Policy remained unchanged throughout the period relevant to the issues raised.
- All of the common (participating) shares of Aco are held by Mr. X's family trust ("Trust X").
- Trust X is a discretionary personal trust. Xco is both a capital and income beneficiary of Trust X.
- Xco is a holding company controlled by Mr. X.
- Aco and Xco are taxable Canadian corporations.
- Aco and Xco are connected corporations within the meaning of subsection 186(4) of the Income Tax Act (footnote 1) by virtue of the application of subsection 186(2).
- There is a non-arm's length relationship between Mr. X, Aco, Xco and Trust X.
- All the parties involved are resident in Canada.
- Under discussion is a sale by the shareholders of Aco of all of the shares in the capital stock of Aco to a third party on January 1 of next year.
- There is sufficient safe income on hand attributable to the common shares of Aco held by Trust X in respect of the value of the dividend contemplated below.
- Subsection 75(2) does not apply and has never applied to Trust X.
It is Mr. X's intention that the Policy be transferred to Xco in the following manner:
(1) In the year preceding the sale (“Year A1"), Aco will pay a dividend in kind to Trust X equal in value to the FMV of the Policy, in this case, $250. Trust X will include the $250 dividend income in computing its income.
This will also result in a disposition of the Policy by Aco to Trust X to which subsections 148(1) and (7) will apply. Pursuant to the application of subsection 148(7), the disposition of the Policy by Aco and its acquisition by Trust X will be deemed to be made at the greatest of the value (footnote 2) of the Policy (i.e., its CSV of $150), the FMV of the consideration given ($0) and the ACB (footnote 3) of the Policy ($50). Aco would therefore have a taxable policy gain of $100.
(2) On December 31 of Year A1, Trust X will make a payment in kind in an amount equal to the dividend in kind (equal to the FMV of the Policy, i.e., $250) by transferring ownership of the Policy to its beneficiary, Xco, in accordance with subsections 104(6), (13) and (24). The deed governing Trust X permits a payment in kind. Trust X will also allocate and designate this amount to Xco in its income tax return for Year A1 in accordance with subsection 104(19). That amount will be included in the income of the beneficiary, Xco, and will retain its nature as a dividend since all the conditions set out in subsection 104(19) will be satisfied. Since Aco is connected to Xco in accordance with the rules in subsection 186(4), and the dividend does not entitle Aco to a dividend refund, Part IV tax will not apply to Xco. Since Xco is a corporation, no Part I tax will result because of the deduction provided for in computing taxable income pursuant to subsection 112(1).
Questions to the CRA
(a) In Technical Interpretation 2011-0391781E5 (footnote 4), the CRA confirmed that, where a life insurance policy owned by a personal trust is distributed to a beneficiary resident in Canada in satisfaction of all or a portion of the beneficiary's capital interest in the trust, provided that subsection 107(4.1) does not apply to the distribution, subsection 107(2) takes precedence over subsection 148(7) so that there would be a tax-deferred rollover. By analogy, where Trust X transfers the Policy to Corporation X as a payment pursuant to subsections 104(6), (13) and (24) (designated pursuant to subsection 104(19)), will subsection 106(3) prevail over subsection 148(7), so that Trust X is deemed to have disposed of the Policy for proceeds equal to the FMV of the Policy?
(b) If subsection 148(7) prevails over subsection 106(3), where Trust X distributes the Policy to Xco as a payment pursuant to subsections 104(6), (13) and (24) (designated pursuant to subsection 104(19)), can CRA confirm what Trust X's proceeds of disposition of the Policy will be?
(c) Assume that in Steps 2 and 3, on December 31 of Year A1, instead of surrendering the Policy, Trust X issued a promissory note to Xco for an amount equal to the FMV of the Policy, the promissory note being payable on demand by the beneficiary, without any conditions being attached to the beneficiary's right. In the course of Year A2, the promissory note would be repaid by the transfer of the Policy from Trust X to Xco.
In this context, would subsection 107(2) apply to the distribution of the Policy by Trust X to its beneficiary, Xco, in Year A2?
CRA Response to Questions 4(a) and 4(b)
In order to determine whether subsection 106(3) should apply in the situation described, it must first be determined whether Xco would receive the interest in the Policy in satisfaction of all or any part of its income interest in Trust X. If the answer to this question is yes, it must next be determined whether subsection 106(3) should then take precedence over subsection 148(7).
In order to conclude that Xco would receive the interest in the Policy in satisfaction of its income interest in Trust X, it would be necessary, first, for the interest in the Policy to form part of the income of Trust X for private law purposes (taking into account subsection 108(3)) (footnote 5) and, second, that Xco is the beneficiary of the income of Trust X and is entitled to receive the interest in the Policy in accordance with the terms of the deed governing Trust X.
The determination of whether property received by a trust by way of a dividend in kind would be income or capital to the trust receiving it is a mixed question of law and fact. Such a determination can only be made following an exhaustive analysis of the applicable private law (in the case of a trust governed by Quebec civil law, Articles 909 and 910 C.C.Q.) and all the relevant facts and documents. That said, our understanding is that, generally speaking, under the applicable private law, the interest in a life insurance policy received by a trust by way of a dividend in kind paid by a corporation of which it is a shareholder would form part of the trust's income.
The distribution by Trust X of its interest in the Policy to its corporate beneficiary, Xco, would result in a disposition by Trust X of that interest in the Policy. Where income, for the purposes of subsections 104(6) and (13) (footnote 6), of a trust paid to a beneficiary is income within the meaning of the applicable private law and the trust pays that income in kind to the beneficiary by the distribution of property (such as an interest in a life insurance policy) in satisfaction of all or any part of the beneficiary's interest in the income of the trust (footnote 7), subsection 106(3) could apply. Subsection 106(3) provides that, in such a situation, the trust is deemed to dispose of the property for proceeds equal to its FMV.
Subsection 148(7) applies where an interest of a policyholder in a life insurance policy is disposed of in any manner to a person with whom the policyholder was not dealing at arm's length. Under paragraph 251(1)(b), a personal trust (footnote 8) and its beneficiary are deemed not to deal with each other at arm's length. Thus, subsection 148(7) could apply where a trust transfers its interest in a life insurance policy to one of its beneficiaries.
Where subsection 148(7) applies to a disposition occurring after March 21, 2016, the policyholder is deemed to become entitled to receive, at the disposition time, proceeds of the disposition equal to the greatest of (i) the value of the interest at the time of disposition (footnote 9), (ii) the FMV at the disposition time of the consideration, if any, given for the interest, and (iii) the ACB to the policyholder of the interest immediately before the disposition time. Pursuant to paragraph 148(7)(b), the person who acquires the interest as a result of the disposition is deemed to acquire it, at the time of the disposition, at a cost equal to that same amount.
In the case of the distribution of an interest in a life insurance policy by a corporation to its shareholder by way of a dividend in kind, CRA's position is that there is no consideration given for the interest for the purposes of clause 148(7)(a)(ii)(B). This position does not apply to the situation described, where a trust transfers its interest in a life insurance policy to its beneficiary. When a trust transfers property to a beneficiary, whether in payment of the trust's income or capital under the applicable private law, the beneficiary gives consideration for the transfer. This consideration may be all or any part of the beneficiary's income or capital interest, as the case may be.
Determining the FMV of an income interest in a trust at a particular time is a question of fact that can only be determined after considering all the relevant facts, circumstances and documents. However, in the situation described, to the extent that it would be determined that at the time of the disposition of the Policy, for the purposes of clause 148(7)(a)(ii)(B), the Xco beneficiary's income interest in Trust X included the right to require Trust X to pay an amount equal to the FMV of the Policy, it could then be argued that the part of Trust X's income interest that was given by Xco for the interest in the Policy had an FMV equal to the FMV of the Policy. In that context, the consequences of the disposition of the interest in the Policy would be the same for Trust X and Xco, regardless of whether subsection 106(3) or subsection 148(7) would prevail. It is not clear that such a result is consistent with tax policy. The CRA will bring this conclusion to the attention of the Department of Finance.
CRA Response to Question 4(c)
Subsection 107(2) applies inter alia if property of a personal trust is distributed by the trust to a beneficiary and there is a resulting disposition of all or any part of the beneficiary’s capital interest in the trust and certain additional conditions are satisfied.
In the situation described, in Year A2, Trust X would distribute its interest in the Policy in full payment of the promissory note it owed to its beneficiary Xco. Trust X would therefore repay a debt to its beneficiary by a payment in kind. Subsection 107(2) would not apply in those circumstances, since this would not be a situation where a distribution of trust property gives rise to a disposition of all or part of the beneficiary's capital interest in the trust. Rather, it would be a situation where a debtor repays its debt to its creditor.
The transfer by Trust X of its interest in the Policy to its beneficiary, Xco, in repayment of the note would be a disposition to which subsection 148(7) would apply since Trust X is deemed not to deal at arm's length with Xco by paragraph 251(1)(b).
In the situation described, the application of subsection 148(7) on the distribution by Aco of its interest in the Policy to its shareholder Trust X by way of a dividend in kind would result in Trust X being deemed to have acquired the interest in the Policy at a cost equal to $150 pursuant to paragraph 148(7)(b).
In Year A2, Trust X would be deemed by paragraph 148(7)(a) to have acquired the right to receive, at the time of disposition, proceeds of disposition equal to $250 (the greatest of (i) the CSV of the interest at that time ($150), (ii) the FMV, at that time, of the consideration given for the interest ($250) and (iii) the ACB of the interest to Trust X immediately before that time ($150)).
Regarding the consideration given for the interest, in the situation described, since the transfer of the interest in the Policy by Trust X to its beneficiary Xco would be in repayment of the promissory note, the consideration given by the beneficiary would correspond to the amount of the debt repaid. The FMV of the consideration given for the interest in the Policy would therefore be the FMV of the note, which, in the situation described, would represent an amount equal to the FMV of the interest in the Policy, i.e., $250.
The result for Trust X would be a taxable policy gain of $100 in respect of the disposition of the interest in the Policy. Pursuant to paragraph 148(7)(b), Trust X would be deemed to acquire the interest in the Policy at a cost equal to $250.
Nathalie Boyer
November 3, 2023
2023-099053
FOOTNOTES
Due to the requirements of our systems, the footnotes contained in the original document are reproduced below:
1 R.S.C. 1985, c. 1 (5th Supp.) ("I.T.A.").
2 As defined in subsection 148(9) I.T.A.
3 As defined in subsection 148(9) I.T.A.
4 CANADA REVENUE AGENCY, Technical Interpretation 2011-0391781E5, January 18, 2012.
5 Subsection 108(3) I.T.A. provides that for certain specific purposes of the Income Tax Act, including the definition of "income interest" in subsection 108(1) I.T.A., the concept of income means the income of a trust computed without reference to the provisions of the Income Tax Act. Thus, for these purposes, the income of a trust governed by the civil law of Quebec is determined according to the rules of the Civil Code of Quebec ("C.C.Q.")
6 Income as determined under the Income Tax Act without reference to subsections 104(6) and (12) I.T.A.
7 According to the definition of "income interest" in subsection 108(1) I.T.A., a taxpayer's income interest of a trust includes a right to enforce payment of an amount from the trust where that right arises from the taxpayer's rights to receive income as a beneficiary under a personal trust.
8 Other than a trust described in any of paragraphs (a) to (e.1) of the definition of "trust" in subsection 108(1) I.T.A.
9 "Value" is defined in subsection 148(9) I.T.A. and generally means the CSV of the Policy, where the interest includes an interest in the CSV of the Policy.