Today’s blog post was written by Pritika Deepak, an Associate at Fasken LLP.
This is Part II of a three-part blog series which provides a high-level overview of some of the tax implications to consider, with respect to certain assets held at death. Part I, which addresses RRSPs can be found here: https://www.allaboutestates.ca/what-happens-when-a-taxpayer-dies-with-a-registered-retirement-savings-plan/
Part II of the blog focuses on life insurance policies owned at the time of death. Specifically, this article will consider “exempt” life insurance policies and their tax treatment on the death of an individual.
*Please note that this article is for general informational purposes only and is not intended to provide a comprehensive review of the various tax consequences and considerations relating to life insurance policies. Readers should contact their attorneys and life insurance advisors to obtain advise with respect to their particular situations.
Life insurance policies are useful tools which are often used to fund expenses that arise on an individual’s death, including personal debts, funeral costs, probate fees, and taxes.
There are generally two categories of life insurance policies: whole life/permanent life and term life. As their names suggest, a permanent life insurance policy lasts for the entire life of the insured, while a term life insurance policy only covers a specific period of time. Although there are several variations of permanent and term life insurance policies, the tax treatment of the proceeds of life insurance of the deceased will generally depend on whether the policy is considered an “exempt” policy.
What is an “Exempt” Life Insurance Policy?
The Income Tax Act (RSC, 1985, c. 1 (5th Supp.)) (“ITA”) distinguishes between policies which are primarily acquired for insurance protection and those acquired for investment accumulation. The comprehensive test to determine whether a particular policy qualifies as an “exempt” policy is performed by comparing the actual policy with a theoretical benchmark outlined in sections 306 and 307 of the Income Tax Regulations (“Regulations”). Generally, policies which are clearly designed for insurance protection are likely to satisfy the “exempt policy” test outlined in the Regulations. In such policies, the insurance component (separate from the investment element) is seen as the predominant portion of the policy, thereby justifying a tax exemption upon death. Most often, dealing with exempt policies and policy composition is the domain of actuaries and not lawyers.
Taxation of Proceeds of an Exempt Life Insurance Policy on Death
It is very common for individuals to designate a spouse, children or other family members as individual beneficiaries of their life insurance policy. Where the beneficiary is an individual, the proceeds of an exempt life insurance policy are generally received tax-free and do not need to be reported by the beneficiary for income-tax purposes.
For business owners and shareholders of private Canadian corporations, it is common for the ‘key person’ and/or shareholders to be insured. Commonly, the policy is owned by the corporation which is also designated as the beneficiary of the policy. This allows the corporation to generally receive the death benefits free of tax.
The tax-free proceeds, less the adjusted cost basis of the insurance policy, received by a corporate beneficiary are usually added to a private corporation’s capital dividend account (“CDA”). The CDA is used to keep track of various tax-free surpluses accumulated by a private corporation. The balance in the CDA may, in turn, be distributed tax-free in the form of dividends to the corporation’s Canadian resident shareholders. In this manner, the corporate beneficiary can make tax-free payments in the form of dividends to the deceased shareholder’s estate. It is important to note that in cases where there is a capital loss, the capital loss may cause the available CDA balance to be reduced.
Where immediately prior to death, an individual holds an interest in a policy on the life of some other person (i.e. the deceased was a policyholder), the death of the policyholder results in a disposition of the policy for income tax purposes. On the death of the policyholder, if there are no successor owner designations, where the policyholder is not the life insured, the policy passes through the policyholder’s estate and subsequently to the beneficiary of the policyholder’s estate.
Pursuant to paragraph 56(1)(j) and section 148 of the ITA, the disposition determines the policy gain which must be included in the deceased policyholder’s income. Pursuant to subsection 148(1), the income inclusion is equal to the amount (if any) by which the “proceeds of disposition” of the policyholder’s interest exceeds the “adjusted cost basis” of the policyholder.
“Proceeds of disposition” is defined in subsection 148(9) of the ITA to be the amount of proceeds that the policy holder is entitled to receive on the disposition of the interest in the policy. This generally refers to the cash surrender value of the interest adjusted for outstanding policy loans and unpaid premiums.
“Adjusted cost basis” is calculated based on a complex formula set out in subsection 148(9) of the ITA. In simple terms, the adjusted cost basis essentially represents the cost amount of a policyholder’s interest in a life insurance policy and varies based on transactions and the passage of time.
There are a few exceptions to the income inclusion rule stipulated in paragraph 56(1)(j) and section 148 of the ITA. One exception is when the policyholder’s interest in a life insurance policy is transferred to a surviving spouse or common-law partner, as a consequence of death of the policyholder. In such circumstances, a ‘rollover’ is available whereby the surviving spouse or common-law partner will acquire the life insurance policy at its adjusted cost basis. A second exception applies to situations where a life insurance policy on a child’s life is owned by a parent. Such a policy can also be transferred on a ‘rollover’ basis to the child, where the child is named as the successor owner of the life insurance policy.
There is a great degree of complexity involved in properly using life insurance policies in an estate plan. However, given the potential tax savings available to Canadians, it is essential that individuals connect with the appropriate planners and advisors to optimize probate savings through efficient estate and life insurance planning.
 A corporation paying a capital dividend must follow specific procedures including filing an election in respect of the dividend, to ensure the dividend is treated as a capital dividend in the hands of the shareholder.
 The rules regarding the reduction of a CDA are complicated, fact-specific and outside the scope of this article.