Insurance premiums could retroactively disqualify rollover to spousal trust

By Doug Carroll | April 26 2016 07:00AM
At issue

Life insurance is a regularly-used estate planning tool, often quantified in part to satisfy a capital gains tax liability on death. As capital property can transfer – or ‘rollover’ – between spouses at adjusted cost base (ACB), insurance proceeds for this purpose would not be required until the second death of the two, and the insurance may be structured with that in mind. (In this article, the term spouse includes a common-law partner.)

Trusts are also central tools in wealth and estate planning. A transfer of capital property to a spousal trust can (but does not have to) occur on a rollover basis. As long as the trust does not dispose of that property during the spouse-beneficiary’s lifetime, capital gains recognition will be deferred until that person’s death.

But where life insurance and a spousal trust are married together (pun intended), it could lead to a retroactive negative tax result.

Income Tax Act (ITA) Canada – Sections 70(6) and 73(1.01)

The main rules enabling a rollover to a spousal trust are in ITA s.73(1.01) for inter vivos (lifetime) transfers, and ITA s.70(6) for testamentary transfers. For present purposes, the requirements are essentially the same either way. The result of the successful application of the rules is that the transferor has deemed proceeds equal to his or her ACB, and the trust is deemed to have acquired the assets at that same amount.

In addition to both the parties having to be Canadian residents at the time of the transfer, the trust must comply with ongoing rules regarding income entitlement and access to capital. Specifically,

  • The spouse-beneficiary must be entitled to all income of the trust during his/her lifetime; and
  • No-one but the spouse-beneficiary may receive or otherwise obtain the use of any of the income or capital of the trust before that person’s death.

Carefully reading the second proviso, the spouse-beneficiary does not have to be entitled to the capital in order for the rollover to apply. A typical application might be a second-marriage spouse-beneficiary having use of a house, cottage or other capital for life, with the capital to be distributed to the first-marriage children upon the beneficiary’s death.

2014-0529361E5 (E) – Spousal trust & life insurance, November 16, 2015

This CRA letter deals with the use of trust assets to pay life insurance premiums, where the proceeds of the insurance will be paid to a policy beneficiary.

At issue is the constraint on access to the capital of the trust. Though the contents of the taxpayer’s letter are not quoted directly, the CRA letter begins with an acknowledgement of common ground “that the relevant legislation does not contain a requirement that the spouse “benefit” from the trust while alive.” However, it goes on to raise the concern whether someone other than the spouse-beneficiary may be obtaining the use of the trust capital or income. 

The taxpayer’s argument appears to have been that as nothing is received before the spouse’s death, the premium payments should not be considered as property used by the residual beneficiaries. This position is rejected, and instead characterized by the CRA as the use of trust property to establish the residual beneficiaries’ rights to the funds from the policy, the realization of which will simply occur after the death of the spouse.

The upshot is that payment of such insurance premiums would disqualify the trust from ever being a spousal trust eligible for a capital property rollover.

Notably, it took the CRA a year-and-a-half to respond to this letter, which is a bit longer than usual. The opening states that the “submission received careful consideration”, an unnecessary but arguably telling indication that extended time was required to grapple with the merits of the arguments. As well, the closing advises that the submission was also forwarded to the Department of Finance, the responsible legislative department (as compared to the CRA being an administrative body). 

Practice points
  1. Life insurance remains a useful tool for dealing with tax liabilities, but its ownership, funding source and beneficiary designations must be carefully considered in light of CRA’s position in this letter. Any contemplated workaround (for example a parallel trust for the insurance alone) should be reviewed by legal and tax advisors to be sure the problem is adequately addressed without causing other undesirable consequences. 
  2. Some insurance-based concepts, for example an insured annuity, may be positioned as a means to improve investment returns. Though they may be shown not to harm a spouse-beneficiary – and possibly even to increase lifetime income – such concepts would appear to be problematic for spousal trusts.
  3. CRA’s open notice that it was sharing the submission with the Department of Finance may be a ray of hope that this may not be the final word on the issue.