Know Your CDA

Exploring the impact of policy transfer rule changes

Many shareholders of private corporations have transferred life insurance policies to corporations in the past. Tax changes to the policy transfer rules in 2016 could impact the credit to the capital dividend account (CDA) of a corporation on the death of the life insured. As demonstrated by the following example, understanding these rules is key to getting the CDA calculation right when the corporation receives the death benefit.

Our Example

Assume that on December 1, 2015, a valuation was performed on a $2-million permanent policy owned by Mr. X, the sole shareholder of a private corporation. The policy’s cash surrender value (CSV) and adjusted cost basis (ACB) at the time were $120,000 and $200,000, respectively. The valuation determined the fair market value (FMV) of the policy to be $400,000.

On the same date, Mr. X transfers ownership of the policy to the corporation for a promissory note in the amount of $400,000, and the corporation is named as beneficiary of the policy.

Under the tax rules at that time, the shareholder would be deemed to have disposed of the policy for proceeds of $120,000 (i.e., the CSV of the policy) and no gain would arise for tax purposes. In addition, the starting ACB to the corporation would be equal to the CSV of the policy, which was $120,000. The result is the extraction of $400,000 from the corporation without tax to the shareholder (payments to settle the promissory note can be received tax-free) and the “resetting” of the ACB to $120,000 — $80,000 less than it was in the hands of the shareholder.

Life insurance proceeds create a credit to a private corporation’s CDA, which permits the payment of tax-free capital dividends. The amount added to the corporation’s CDA from life insurance proceeds is generally equal to the proceeds received minus the policy’s ACB immediately before death. Therefore, resetting the policy’s ACB to a lower amount may be significantly favourable to beneficiaries of Mr. X’s estate.

Change In Rules

The rules changed for such policy transfers made after March 21, 2016, and now the policy ACB and FMV of any consideration paid by the corporation for the policy is factored into the calculation of proceeds of disposition to the shareholder. Thus, had the policy transfer taken place four months later, Mr. X would have a policy gain of $200,000 (i.e., proceeds of $400,000 less ACB of $200,000) and the starting policy ACB to the corporation would have been $400,000.

Does this mean that, in our example, Mr. X executed the planning “just under the wire”? Unfortunately, what goes around, comes around. The 2016 changes also introduced rules intended to offset advantages realized on previous transfers. These rules adjust the calculation of the CDA at the time life insurance proceeds are received by the corporation. The rules are applicable when anyone, other than a taxable Canadian corporation, had previously transferred a policy to the corporation after 1999 and before March 22, 2016.

The Calculations

The first adjustment, often referred to as the “hard grind,” is calculated as:

FMV

•

•

In our example, the hard grind reduces the CDA by $200,000, calculated as the FMV of consideration received by Mr. X of $400,000 minus the ACB of the policy at the time of transfer of $200,000.

The second calculation (the “soft grind”) is more complex and designed to offset the advantage of resetting the starting ACB of the policy in the hands of the corporation. Let’s assume the ACB reduces by $150,000 from date of transfer to time of death of the life insured. In that case, the ACB of the policy immediately before death would be –$30,000 (starting ACB of $120,000 less reduction of $150,000). However, the tax rules dictate the ACB cannot be less than zero. The soft grind is calculated as follows:

Amount by which the lesser of:

• FMV of consideration received by the shareholder

• ACB at the time of transfer exceeds CSV at the time of transfer, minus the absolute value of any negative ACB immediately before death

In our example, the soft grind is $50,000 (i.e., the amount by which the ACB of $200,000 at time of transfer exceeds the CSV at time of transfer of $120,000, which is $80,000, minus the absolute value of the negative ACB immediately before death of $30,000 = $50,000). If the ACB was not reset under the old rules, the ACB for tax purposes at time of death would be $50,000 (i.e., ACB in the hands of Mr. X immediately before the transfer of $200,000 minus $150,000 of ACB reductions from time of transfer to time of death) — but instead it is zero ($120,000 minus $150,000, which is zero for tax purposes). The soft grind eliminates this $50,000 difference by reducing the CDA by that amount.

In the final analysis, the addition to the CDA in our example would be $1,750,000, calculated as $2 million (death benefit) minus $0 (ACB) minus $200,000 (hard grind) minus $50,000 (soft grind). While this would be the same CDA credit if the transfer took place after the 2016 changes, the taxpayer did benefit from having the use of $400,000 (tax-free) received at the time of transfer.