New Judicial Guidance on Life Insurance Policies and Capital Dividend Accounts

Life Insurance policies are often assigned to creditors to provide for the discharge of a loan on the death of a shareholder or key employee of a private company. Upon the death of the individual, the life insurance proceeds are used to pay off the loan, with the proceeds in excess of the adjusted cost base added to the corporation's capital dividend account. The balance of the capital dividend account is then available for a tax-free distribution to the shareholders.

Historically, it has been the Canada Revenue Agency's (CRA) policy to deny the addition of the life insurance proceeds to the capital dividend account. The basis for that position was outlined in paragraph 6 of IT-430R3 and Income Tax Technical News No. 10, which denied the addition to the capital dividend account when the proceeds of the life insurance policy are paid directly to the creditor as a beneficiary, or where the creditor is an absolute assignee for security. Despite the fact the debtor paid the premiums on the policy, the CRA viewed the addition of the capital dividend account as remaining with the creditor rather than the debtor. 

The CRA traditionally held that the corporation did not receive the proceeds as a beneficiary as required by the definition of "capital dividend account" under sub-section 89(1)(d)(ii) of the Income Tax Act, which definition includes:

all amounts each of which is the proceeds of a life insurance policy... received by the corporation... in consequence of the death of any person....

However, the recent decision of the Federal Court of Appeal in Innovative Installation Inc. v. R. (2010 FCA 285) provides a different interpretation of the definition.

In the case, Innovative Installation Inc. (Innovative) had a business loan with the Royal Bank of Canada (RBC) and was enrolled in a group creditor life insurance policy set up by RBC with Sun Life. The policy provided for the discharge of the loan upon the death of the principal of Innovative. Innovative paid the premiums to RBC as part of its loan repayments, and RBC remitted them to Sun Life. Upon the death of Innovative's principal, Sun Life paid the proceeds of the policy to RBC as the policy-holder and RBC was contractually obligated to discharge the loan with those proceeds. In these circumstances, the Minister denied the addition of the life insurance proceeds to Innovative's capital dividend account.

The Tax Court of Canada and the Federal Court of Appeal disagreed, however, holding that Innovative "received" the proceeds of the policy - for purposes of the definition of "capital dividend account" - when RBC applied the proceeds to discharge the loan, as required by the contract. The definition did not require the corporation to receive the proceeds directly from the insurer or that it be named as a beneficiary of the policy. As such, the life insurance proceeds were properly added to the capital dividend account, in contrast to the CRA's historical position.

The Innovative case would suggest, then, that it is irrelevant who the owner and beneficiary of the policy is or who physically receives the proceeds from the life insurance. The effect for tax practitioners could be a reduction in the administrative burden in structuring insurance policies as security for debt. It has yet to be seen whether the CRA will update its administrative position and Interpretation Bulletin IT-430R3 to reflect the outcome of this case.

Guy A. Desmarais, B. Com., LL.B., TEP, is a Tax Partner in the Sudbury-Nipissing office of Collins Barrow and can be reached at gudesmarais@collinsbarrow.com.

Tony Alberton is a CA and a Senior Tax Manager in the Sudbury-Nipissing office of Collins Barrow and can be reached at 705-560-5599 ext.295