The Bottom Line February 2012 21F I NA N C I A L P L A N N I N G

For many business owners who have seen their busi-nesses flourish through

years of hard work, one con-t inuing diff icul ty is how to unlock the wealth held captive in their corporations. One method of gaining access to some of those retained earnings in a tax-effective manner is through the sale of a personal life insurance policy to a non-arm’s-length cor-poration.

When an individual share-holder owns a life insurance policy — either permanent, or a term policy that is convertible to permanent — it can be sold to the corporation. As that transaction would be determined to be not at arm’s length, Section 148(7) of the Income Tax Act will apply and

the shareholder will receive funds from the company equal to the policy’s fair market value (FMV). The individual would be subject to taxation as income the amount by which the policy’s cash sur-render value (CSV) exceeds the adjusted cost base (ACB).

The company’s ACB for the policy is not deemed to be the FMV, but rather, as directed by Section 148(9), the CSV. This typically allows the bulk of the death benef it to flow tax-free through the capital dividend account upon the death of the insured.

Frequently, life insurance is valued using a simple method-ology: Term policies are held to have no value and permanent pol-icies are said to be worth the CSV. However, when determining an accurate value is important, the FMV is used. According to Canada Revenue Agency’s infor-mation circular 89-3: “FMV is def ined as the highest price obtainable in an open and unre-stricted market between knowl-edgeable informed and prudent parties acting at arm’s length, neither party being under any compulsion to transact.”

A number of variables can give rise to a FMV being consid-erably higher than the CSV, the

most critical of which is the underlying health of the insured. If the individual has suffered a deterioration of health that would give rise to a rating, or uninsur-ability, then the FMV will start to approach the death benefit. Other variables that can result in a higher FMV include conversion provisions or changes in the underlying pricing of the policy.

For example, consider a busi-ness owner who has a permanent life insurance policy with a face value of $1-million. The policy’s CSV is $350,000 and the ACB (essentially the accumulation of all policy premiums paid over the years) is $275,000. After suf-fering a heart attack, the owner decides they would like to remove some money from his business, and commissions a fair market valuation of their life insurance policy given their new health status.

After the medical data is reviewed, an actuary has deter-mined that the policy’s FMV is $750,000. The owner transfers the policy to their corporation and takes out $500,000 in cash and a $250,000 promissory note. The company acquires the policy with a new ACB of $350,000 and the business owner pays tax on income of $75,000 (CSV less

ACB before the policy’s transfer).There are some issues that a

business owner should be aware of when holding a permanent life insurance policy inside a corpo-ration. First, the policy is an asset of the corporation and exposed to creditors, so it does not enjoy the same level of creditor protection as many personally-owned poli-cies do. Second, the CSV of the policy is considered a passive asset of the corporation. Care should be taken that the policy does not impede the owner to use the capital gains exemption if he or she sells the corporation.

Additionally, if the shares of the company are subsequently sold, the business owner will likely want to transfer the policy to personal ownership, with potential income tax conse-quences. All of these factors mean that holding companies tend to be more popular vehicles for holding life insurance policies than do operating companies. Finally, any policy that is trans-ferred to a corporation through a fair market valuation should be held to maturity.

There are several other situa-tions where one may want to engage a fair market valuation of a life insurance policy. Many incorporated doctors, dentists,

accountants and lawyers own one or more life insurance policies and wish to transfer those poli-cies to their corporation so that the payment of policy premiums can be made with corporate dol-lars, allowing for substantial increases in the accumulated value of those policies. The gifting of insurance policies to registered charities can make use of a fair market valuation to ensure that a tax receipt is issued for the maximum al lowable amount.

A d d i t i o n a l ly, c o r p o r a t e freezes, transfer of assets from an operating company to a holding or sister company, or the sale of a business where businesses own insurance policies, will all give rise to valuation requirements, as will a marriage breakdown.

Insurance policy can tap business wealthMerrickweAlTh

By PeterMerrick

Peter J . Merrick, BA, FMA, CFP, TEP, FCSI is a trust and estate prac-titioner and president of Merrick-Wealth.com, an exit planning firm in Toronto. He is the author of The Essential Individual Pension Plan Handbook (LexisNexis Canada, 2007) and The TASK – The Trusted Advisor’s Survival Kit (LexisNexis Canada, 2009). He can be reached at Peter@MerrickWealth.com or 416-854-1776.

than bad on the governance front, he continued. Independent direc-tors are taking a stronger stance and becoming more inquisitive, some even meeting “in-camera” without the CEO or senior man-agement after board meetings to discuss responses without having to confront them in order to pre-serve the board-senior manage-ment relationship.

“They may not feel comfort-able asking the tough questions of the CEO directly,” he said.

Keeping the make-up of the board fresh is also important, he said, and the banks were the first to set terms for directors.

“Now, if you’re appointed to a board at 55 years old, it’ll still be 15 years and you’ll be 70, which is still a long time,” he said. “But without terms it’s almost impos-sible to get rid of a director. You spend your first f ive or so years on the learning curve and then the last nine or 10 you’re expected to punch above your weight.”

Terms are also coming to the not-for-profit sector, he said, and are about six to eight years away from being standard.

Staying too long means direc-tors get too cozy. Other jurisdic-tions, such as Britain, have rules that say that, after 12 years, a dir-ector no longer qualifies as being

an independent, Powers said.“That’s important, because if

you’re not an independent you can’t sit on the audit committee or the compensation committee, so what good are you? It’s easier then to push them off the board.”

Directors and their boards are a lso increasingly subject to assessment reviews, he said: “They have to meet attendance rules, and if they can’t attend 80 per cent of the meetings they can’t be on that board — they’re too busy.”

Shareholders also expect the interests of the board to align with those of the company, so dir-

ectors are being paid in a com-bination of a retainer and stock options.

At the same time, shareholders are also demanding a say on pay for CEO and other executives, and more shareholder activist groups are stepping up to target specific boards and demand open annual-general-meeting voting by individual candidate rather than by slate.

“Who’d have thought 30 years ago that the shareholders would have a voice on what to pay the CEO?” he asked. “But that’s exactly what is happening.”

There is a limit. In Canada, say-on-pay is not mandatory and likely won’t be, he said.

Boards are also becoming more diverse, though in Canada the average board is typically “male, stale and pale.” Women make up half the work force but less than 10 per cent are direc-tors, even though studies show women make organizations more efficient.

It’s not impossible to f ind

qualified women, he said, noting in 2005 Norway threatened legal action if 40 per cent of directors

weren’t women by 2009. Sud-denly, they started f inding and appointing women.

Higher expectations are driving reformsContinued from page 9

PoWeRs

“Who’d have thought 30 years ago that the shareholders

would have a voice on what to pay the CEO?

But that’s exactly what is happening.”

Rick Powers, Rotman School of Management

Kick off the Tax Season! Canada Wide

lPersonal Tax Update 2012

l How to Prepare a Personal Tax Returnfrom Start to Finish

l Commentary on the Federal Budget

(major changes expected)

TO REGISTER:1-877-438-2057 www.videotax.com