Recent proposals by the federal government to change the way private corporations are taxed are garnering mixed reactions from the life insurance industry.
In July, the Department of Finance Canada released a consultation paper proposing a slew of policy changes that would eliminate certain tax-planning strategies for private corporations.
On one hand, the changes could bolster life insurance sales because fewer alternative tax-planning strategies would be available to business-owner clients. On the other hand, the changes could eliminate certain tax-planning strategies that involve corporate-owned life insurance.
Given the vague nature of the proposals, insurance industry experts such as Kevin Wark, tax consultant at the Conference for Advanced Life Underwriting in Toronto, say further clarification is needed to determine the full effect. “At this time, it’s unclear what impact this legislation would have on corporate-owned life insurance,” Wark says.
As life insurance has unique tax treatment under the Income Tax Act, insurance advisors such as Asher Tward, vice president of estate planning with TriDelta Financial Partners Inc. in Toronto, say insurance is unlikely to be affected by the new rules. He notes that in the paper outlining the proposed changes, there were no references to insurance.
“As I understand it, insurance is not affected under these proposals,” Tward says. “If anything, insurance becomes a huge benefit to business owners when all of these other avenues are being shut down.”
Given the uncertainty around the proposed changes, advisors such as Dale Abrams, president of Abrams Financial in Toronto, are waiting to see how things unfold before advising business-owner clients on how to proceed.
“Everyone has hit the pause button right now,” he says. “Everything is very vague.”
One area of ambiguity is the proposed change to the taxation of passive income, which would eliminate the opportunity for business owners to defer paying taxes on income derived from investments within their corporation.
Whether a corporate-owned life insurance policy is likely to be included in that category is unclear, says Trevor Parry, president of TRP Strategic Consulting and partner at Pension Acuity Partners in Toronto.
“The big fear is the deferral rules,” Parry says. “Is life insurance passive or not?”
One scenario in which the changes to passive income taxation might have an impact is if a business owner cashes out a corporate-owned life insurance policy prior to death – a situation in which the proceeds could be taxable.
“If the policy is held corporately and it’s disposed of at a gain, this would likely be treated as passive investment income and would be subject to these rules,” Wark says.
The proposals involving the conversion of income into capital gains may also affect tax planning that involves life insurance. A post-mortem planning strategy commonly referred to as “pipeline planning,” used to avoid the double taxation that can occur upon the death of a shareholder of a private corporation, would no longer be viable. Life insurance is often used in conjunction with that strategy to fund the remaining tax liability, according to Parry.
The proposed amendments relating to converting income to capital gains would have taken effect on the date of the release of Finance Canada’s consultation paper in July. That means clients who had been in the process of implementing the pipeline strategy at that time could be stuck with a big tax bill for shares in question, Parry says.
“The retroactive element of these proposals has put in jeopardy many post-mortem plans that are in the midst of execution,” he says, “exposing these companies to taxation in excess of 70% without remedy.”
Redemption and loss carryback
An alternative post-mortem strategy, called the “redemption and loss carryback strategy,” should remain viable for clients seeking to avoid the double taxation associated with the death of a shareholder. That approach, which also can involve life insurance, is likely to be used more often in the absence of pipeline planning, Parry says.
At a recent tax conference in Ottawa, a Finance Canada official said the government is reviewing the impact of the proposed changes on post-mortem planning strategies. The proposal could be revised to facilitate certain transactions that prevent double taxation on death, Wark says.
Some life insurance industry stakeholders are concerned about Section 246.1, a new anti-avoidance rule that has been proposed along with the other changes involving the conversion of income into capital gains.
That section, which addresses certain strategies used by business owners to avoid paying dividend taxes, could be used by the Canada Revenue Agency to re-characterize the proceeds of certain corporate-owned life insurance policies as taxable dividends rather than as tax-free capital dividends.
“This provision is so broadly worded that it could apply to many transactions, including insurance planning,” Wark says.
The proposals are not expected to have an impact on the fundamental role life insurance can play as a tax-planning tool. In fact, Tward says, demand for permanent life insurance policies with an investment component – particularly universal life (UL) insurance – is likely to surge if the proposals are implemented.
If the favourable tax treatment of passive investments in a corporation is eliminated, he says, many business owners would be more inclined to invest within life insurance as an alternative way of achieving tax-advantaged investment growth.
“Insurance is going to become a very viable option,” Tward says. “I think there’s going to be a huge opportunity for UL sales in the next couple of years.”
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