The rules governing the taxation of life insurance policies can be confusing for even those in the professional advisory community. If you add to the mix technical interpretations by the Canada Revenue Agency (CRA), tax court decisions and legislative gaps/imperfections, the tax results in certain situations can leave you scratching your head in bewilderment.
In this and future articles we’ll explore some of the more interesting “insurance bloopers and practical jokes” that can lead to unintended planning results for you and your clients. We’ll start the series with a potentially big blooper involving corporate-owned life insurance intended as a charitable gift.
Background on life insurance as a charitable donation
There are a variety of ways life insurance may be used to make a charitable donation. For example, an existing life insurance policy can be gifted to a charity, which can result in a donation receipt equal to the fair market value of the policy. Alternatively, a new policy may be acquired and gifted to a charity, with the donor paying future premiums that qualify for a charitable tax credit.
Another common approach is to designate a charity as a beneficiary of a life insurance policy. Initially, this was not an effective method, as the CRA took the position that the amount paid to a charity under a beneficiary designation was the fulfilment of a legal obligation under the policy and therefore did not constitute a gift. This interpretation meant the donor had to make a gift under their will and have the insurance proceeds paid to their estate to fulfil this gift. The planning community considered this an unnecessary step in the gifting process that exposed the insurance proceeds to probate delays, probate fees and potential claims by creditors.
The CRA’s position was eventually overturned by tax amendments. In 2000 the Department of Finance introduced specific rules that now permit an individual donor to claim a charitable donation credit when a charity is designated as the beneficiary of a life insurance policy owned by the donor. Similar rules were also enacted relating to beneficiary designations in favour of charities under registered plans such as RRSPs, RRIFs and TFSAs.
These rules were subsequently modified in 2014 when a new tax regime governing “graduated rate estates” was introduced. Under the revised rules, when an individual designates a registered charity as the beneficiary of a life insurance policy that they own, a receipt can be issued to the deceased’s graduated rate estate (GRE). In turn, the GRE generally has the flexibility to allocate the donation tax credit to the deceased’s final two tax returns and/or the tax returns of the GRE.
Corporate-owned insurance and charitable gifts
In many respects, the rules governing charitable donations made by private corporations are the same as those governing charitable gifts made by individual donors. However, the charitable donation rules for corporations are set out in Section 110.1 of the Income Tax Act (rather than Section 118.1) primarily because corporations are entitled to claim a deduction rather than a tax credit for making a charitable donation. In many cases the after-tax cost of a charitable gift made by a corporation will be higher than the same gift made by an individual shareholder, due to the increased tax credit available to individuals once donations exceed $200 in a year.
However, this does not mean it is always preferable for the shareholder of a private corporation to make a charitable donation rather than making the donation through their corporation. In fact, there are a number of planning arrangements that make it more attractive from a tax perspective to structure the donation through the shareholder’s private corporation.
For example, using corporate dollars to fund a life insurance policy when the plan is to use the death benefit to make a charitable gift can be more tax effective than holding the policy personally. One advantage is that insurance premiums are not normally deductible for tax purposes, thus making the use of cheaper after-tax corporate dollars to fund the premiums more attractive. Although the payment of the insurance proceeds as a charitable gift by the corporation is also recognized at this lower tax rate, the proceeds paid to the corporation as beneficiary would still qualify for a capital dividend account (CDA) credit, which would allow the future payment of tax-free dividends to shareholders.
What some planners may not realize is that donation rules have not been amended to permit a charitable deduction to be claimed for the proceeds on death when a charity is designated as beneficiary of a corporate-owned policy. In other words, the old CRA interpretations continue to apply, and if a corporation designates a charity as beneficiary of a policy, there will be no charitable deduction available when the proceeds are paid to the charity on the shareholder’s death.
Unfortunately, that’s not the end of the story. The designation of the charity as the policy’s beneficiary also means the corporation is not entitled to a credit to its CDA when the death benefit is paid. This is because the CDA rules require the corporation to be the beneficiary of the policy to be entitled to a credit. This is a double tax whammy and no practical joke!
Fortunately, there is a relatively simple fix that can also result in additional planning flexibility. All that’s required is designating the corporation as beneficiary of the life insurance policy and having a corporate resolution directing the use of the insurance proceeds to make a charitable gift. This allows the corporation to claim a deduction for the charitable gift and also receive a credit to its CDA. It is also possible to structure the gift through the deceased’s estate or from the surviving shareholders, by having the corporation pay out the insurance proceeds to the intended donor as a tax-free capital dividend.
That should make everyone feel good!
Kevin Wark, LLB, CLU, TEP, is managing partner of Integrated Estate Solutions and a tax advisor to the Conference for Advanced Life Underwriting. He is also the author of several tax and estate planning books including the recently updated The Essential Canadian Guide to Estate Planning (3rd Edition).