Corporate Structures and Life Insurance Ownership

Sandra Napoletano, CA National Estate and Tax Consultant

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Important Information

The information provided is based on current tax legislation and interpretations for Canadian residents and is accurate to the best of our knowledge as of the date of publication. Future changes to tax legislation and interpretations may affect this information. This information is general in nature, and is not intended to be legal or tax advice. For specific situations, you should consult the appropriate legal, accounting or tax advisor.

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Update: 2013 Tax Rates

Corporate tax rate (Ont.) 2013> $500,000 active business income 26.5%< $500,000 active business income 15.5%

Personal top marginal rate > $509,000 49.53%Personal top marginal salary rate 46.41%

Immediate deferral> $500,000 active business income 23.03%< $500,000 active business income 30.91%

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2013 Federal Budget Proposals

• Capital gains exemption will increase to $800,000 from $750,000 starting Jan. 1, 2014

• Tax rate on non-eligible dividends increases to 34.21% at top marginal rate and 38.11% if income > $509,0000 (starting Jan. 1, 2014)

• 2013 top marginal rate on non-eligible dividends is 32.57% and 36.47% if income > $509,000

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Benefits of Income Tax Deferral:

• Business expense are less expensive than if paid personally

• Insurance is less expensive, therefore client can afford more coverage

• Less taxes paid upfront allows for cash/wealth accumulation at a faster rate than income earned personally

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Cost Effectiveness of Using Corp. Dollars

Sole Proprietor Corporation

Premium $20,000 $20,000Less corporate tax (e.g.15.5%) - $3,669

Less personal tax (e.g. 46.41%) $17,313 -Pre-Tax Income Needed $37,313 $23,669

Consider the payment of a life insurance premium which is generally not deductible. Assuming a $20,000 annual premium.

Before tax income needed to pay thelife insurance premium

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Typical Client Situation

Your client owns a corporation earning active business income and there is a need for insurance.

Issues:

• Who should be the owner and beneficiary of the policy?• Who should pay the premiums?• Can designate a beneficiary different from owner of the

policy• Beware of CRA’s assessing position (in 2010) for situations

where corporate owner and beneficiary are not the sameAnswers: Depends on client’s objectives and their fact situation

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Typical Client

100%

Mr. X

XYZ Co.

• Mr.X’s wealth is all tied up in XYZ Co.• Mr. X wants to preserve wealth for his family on his death• Insurance will provide the financial security to cover income taxes

at death and estate preservation for his family• Creditor protection is a concern

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- Beneficiary

- Owns policy and pays premiums

• This structure keeps the policy’s value out of the hands of Mr.X’s personal creditors

• CSV becomes XYZ’s asset and can be seized • Not the most tax effective structure because CRA will assess

section 15(1) shareholder benefit in Mr. X’s income for amount of premiums

• Bad result because there will be double tax

Mr. X

XYZ Co.

XYZ Co. owns the policy and Mr. X is designated beneficiary

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• Life insurance policy is exposed to XYZ Co’s creditors• CSV may put XYZ Co offside for CGE & QSBCS status• Alternative owner for policy?

Mr. X

- Owns policy, pays premiums and is the beneficiaryXYZ Co.

XYZ Co is Owner & Beneficiary

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Set up a Holdco

• Transfer of XYZ Co can be done on a tax-deferred basis therefore no immediate tax consequences to Mr. X

Mr. X100%

100%

XYZ Co.

Holdco

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Benefits of Owning Opco Through Holdco

• Dividend planning

• Creditor protection of corporate profits

• Income splitting and succession planning

• Purify Opco to maintain QSBC status

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• This structure is implemented to provide creditor protection for the policy while the life insured is alive

• Avoids tax on disposition should Opco be sold and Holdco wants to retain ownership of the policy

• CRA made comments that s.15(1) shareholder benefit will not apply but s. 246(1) benefit could apply

Mr. X

- Owns the policy and pays premiums

- Designated revocable beneficiaryOpco

Holdco

Holdco owns Policy & Opco is Beneficiary

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What if Opco Reimburses Premiums to Holdco?

• Tax-free dividends can be paid from Opco to Holdco equal to premiums paid

• CRA has commented that there will be no 15(1) benefit to the extent Opco’s reimbursement of premium is included in Holdco’s income under section 9 or 12(1)(x) of the Act

• Not optimal since results in double tax !!!

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Mr. X

- Owner, pays premium & beneficiary

Opco

Holdco

Holdco is Owner & Beneficiary

• Creditor protection concern is addressed• No future disposition of policy required if Opco is sold

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Mr. X

100%100%

- beneficiaryOwner of policy & pays premiums

• SisterCo 2 reimburses SisterCo 1 for the premiums paid• CRA comments are the same as Opco reimbursing Holdco for the

premiums• Results in double tax • Solution is to insert a Holdco

Sister Co2

Sister Co1

Sister Corporations

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Mr. X

- owns policy & beneficiary

100%100%

SisterCo 1 SisterCo 2

Holdco

Sister Corporations cont’d

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• CRA is concerned with the ability of a corporation to avoid having the ACB of a policy grind the CDA credit by having the death benefit paid to a different corporate entity.

• It is therefore very important to be able to demonstrate a bonafide business reason for separating the ownership and beneficiary designation between two corporate entities.

• CRA stated it will closely review any situation where a corporate beneficiary of the policy is different than the corporate owner and the corporations are under common control.

CRA’s Views & Comments

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Mr. X

100%

100%

Opco

Holdco

Capital Gains Exemption

• Mr. X is now concerned with his ability to use his CGE now that Opco has grown in value through profit retention and accumulated non–business assets

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• No tax incentive excites the interest of an owner of a small or medium sized business more than the $750,000 lifetime capital gains exemption

• Tax savings of $174,000 per individual shareholder

• 2013 Federal budget announced proposals to increase exemption to $800,000 for potential tax savings of $198,000 for disposition of shares after 2013

• Applies to capital gains realized on disposition of qualified small business corporation share (“QSBCS”) if strict criteria is met

Capital Gains Exemption cont’d

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1. At the time of disposition 90% or more of the fair market value of the assets is attributable to assets;

i. Used in an active business carried on primarily (more than 50%) in Canada

ii. Shares or debt of one or more SBC that are connected to the corporation, or

iii. A combination of i. and ii.

The share is a share of a small business corporation (“SBC”)

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2. The share was not owned by anyone other than the individual or a person or partnership related to the individual throughout the 24 months preceding the disposition

3. Throughout the 24 months preceding the disposition, the share was owned by the individual or a person or partnership related to the individual & more than 50% of the fair market value of the assets are attributable to types of property relevant for the SBC definition

Capital Gains Exemption cont’d

Anti-stacking stringent rule imposes 50% to be 90% for Opco

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Mr. X

100%

100%

• This structure works for creditor proofing XYZ Co• Creates complications to access capital gains exemption

i. Mr. X needs to sell share of Holdcoii. Buyer wants XYZ Co not Holdco

XYZ Co

Holdco

Common Corporate Structure

Insurance policy

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• Excess cash is paid on a regular and continuous basis as a tax-free dividend to Holdco to the exclusion of Mr. X (assumes no RDTOH in XYZ Co)

• Opco stays “pure” to meet QSBCS status • Substantially all the value of Opco rests with Mr. X to use his CGE on a sale or death• 1% FMV held by Holdco so lose ability to use CGE• What if value of XYZ Co is greater than $750,000? (or $800,000 starting January 1,

2014)

XYZ Co

Mr. X100%

1%

99%

Class B shares

Insurance policyHoldco

Triangle Structure

Class A shares

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Mr. X Mrs. X DaughterSon

Mr. X

Holdco

Family Trust

XYZ Co

Common Shares$750,000 freeze shares

Corporate Beneficiary Structure

(Beneficiaries)

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• Excess cash in XYZ Co is paid on a regular and continuous basis as dividends to the Family Trust

• Trust is a taxpayer for income tax purposes

• Trust pays tax on income not allocated to beneficiaries

• Trust can allocate dividends and capital gains to beneficiaries which retain their character

• Trust pays no tax if all income is allocated to beneficiaries

• Allows XYZ Co to stay “pure”

Corporate Beneficiary Structure cont’d

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• Allows CGE to be multiplied so that each individual beneficiary can be allocated up to $750,000 capital gains

• Holdco must be connected with XYZ Co to receive tax-fee dividends (extended definition of “control” in the Act)

• Complications may arise when arms length shareholders are involved

• $750,000 x 4 individual shareholders = $3M of capital gain sheltered or $696,000 income tax savings on future sale of XYZ Co

Corporate Beneficiary Structure cont’d

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Using CDA in an Insurance Financed Promissory Note (P/N) Buyout

• Mr. A and Mr. B are partners• Mr. A dies• Shareholders Agreement stipulates shares owned by Mr. A are to be

sold to Mr. B after death• Buyout is funded with life insurance proceeds

Mr. B

Opco

Estate Mr. A

50% 50%

- Insurance policy

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•Mr. B buys shares from the Estate of Mr. A at FMV for a promissory noteStep 1:

•Opco declares a capital dividend to Mr. B who uses the proceeds to repay the promissory note to the EstateStep 2:

Buyout with Insurance Financed P/N cont’d

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Insert Holdco to Preserve CDA

Mr. BEstate Mr. A

50%

50%

- Insurance policyOpco

Holdco

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•Mr. B transfers his shares to a newly incorporated Holdco on a tax deferred basis

Step 1:•Holdco buys the shares of a Opco from the

Estate of Mr. A at FMV for a promissory noteStep 2:

•Opco declares a capital dividend to Holdco equal to life insurance proceeds received

Step 3:

•Holdco uses the proceeds to repay promissory note to Estate of Mr. A

Step 4:

CDA Preservation with Holdco cont’d

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CDA Preservation with Holdco cont’d

100%

Mr. B

Opco

Holdco

• Mr. B will have to sell Holdco to utilize CGE, if Holdco is a QSBCS• Can reorganize to crystallize CGE

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• Holdco’s capital dividend account is increased by amount of capital dividends received by Opco

• Paying down promissory note does not reduce CDA balance

• Future retained earnings and value of Holdco can be paid out tax-free via CDA of Holdco to Mr. B

• Capital dividend anti-avoidance rules to consider

CDA Preservation with Holdco cont’d

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Preserve CDA and Utilize CGE

• Allows Mr. B to get bump in ACB by crystallizing CGE• Holdco will buy out 50% from Estate of Mr. A for a note• Assumes Opco’s FMV is $1.5M

Mr. B

Estate Mr. A

50%

common shares

Mr. B

Opco

Holdco

FMV = $750,000

50%

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Preserve CDA and Multiple CGE

Mr. B

Estate Mr. A

50%

common shares

Mr. B, Spouse & Children (beneficiaries)

Opco

Holdco

FMV = $750,000 preference

50%

Mr. B Family Trust

• Beneficiaries can now utilize CGE on future sale of Opco• Trust uses insurances proceeds to buy shares from Mr. A’s Estate• Holdco’s CDA increased via Trust’s capital dividend declared• Holdco pays out future dividends which would otherwise be taxable

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National Estate and Tax Planning Team

Ontario Regional Marketing Centre Resources

• Contact your Canada Life marketing consultant to access your local national estate and tax planning team: – Bryan McNulty, LL.B.– Steven McLeod, LL.B.– Sandra Napoletano, CA.

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Questions?

Thank you