Shared ownership of CI insurance nearing 15-year testBy Alain Thériault | February 24 2015 09:03AM
The concept of shared ownership critical illness insurance for protection of key employees, which emerged about 12 years ago, is poised to pass the ultimate tax test: activation of the 15-year return of premium guarantee. Will key employees be taxed on this refund? Hazy income tax rules mean that anything is possible. A small business owner or key employee is absent for six-months due to critical illness. Who will take over and how can the business find this person? How will firm revenue be affected when an expert employee is on leave?
A policy to protect key employees could resolve these issues, but the industry has gone even further. In the early 2000s it introduced a strategy where key employees in good health could obtain a return of premiums after a predetermined period.
Under this strategy, the critical illness insurance policy is shared between the company and employee, both of whom pay the premiums. The company pays the insurance risk premium, and the employee pays for the return of premium rider. The company is the beneficiary of the insurance amount if the employee gets a critical illness, while an employee who stays healthy benefits from the guaranteed return of premium (ROP).
Unfortunately, this concept is fairly overlooked in the current tax rules. Does the return of premium qualify as a benefit for the key employee? What happens if the company pays part of the insurance amount to a sick employee? Many industry players think this concept will endure if it does not impoverish the company in the employee’s favor. Yet no jurisprudence has demonstrated this beyond doubt. Tax interpretation bulletins published by the Canada Revenue Agency (CRA) barely illuminate this grey area.
The safest path
Diane Hamel assistant vice-president, Regional Tax, Retirement and Estate Planning at Manulife, recommends great caution given this uncertainty. When calculating how to share the premium payments between the shareholder and the company, the advisor must ensure that the cost distribution is reasonable. Even so, the tax authorities may not recognize the validity of the sharing, Hamel cautions.
The technical interpretation letter published by the CRA on Nov. 3, 2006 (no. 2006-017856) touches on this topic, Hamel explains. In the case of a policy where an employee or shareholder is the beneficiary either of an insurance benefit or ROP and the company pays the premiums, the employee or shareholder is deemed to have received a taxable benefit. The CRA extends this position to shared ownership policies.
“The same is true […] in the situation where the corporation pays the critical illness insurance premiums and the shareholder pays the premiums for the return of premium benefit if these transactions give rise to an impoverishment of the corporation,” the letter states. The CRA adds that the premium amount does not necessarily represent the market value of the ROP rider.
The CRA’s letter implies that the distribution of the insurer’s premium is not necessarily recognized, Hamel points out. “Specifically, we cannot conclude that there will be no benefit conferred on the shareholder,” she says. “This is the aspect I find most delicate.”
Advisors should ensure that their customers understand the risks and know what they are getting into, she continues. “Clients must understand that this strategy is risky because its parameters have not been clearly established in the law,” Hamel says. Advisors must rigorously document and analyze these files. She also stresses the importance of writing a formal shared ownership agreement that specifies the rights and obligations of each party.
Stuart Dollar, director of Tax and Insurance Planning for Sun Life Financial, discussed this risk at a talk given to the Conference for Advanced Life Underwriting, or CALU. In his presentation Shared ownership of CI Insurance with ROP: Shareholder benefit issues, he argues that some shared ownership arrangements are riskier than others.
Dollar describes extreme situations and thinks most clients’ situation probably falls somewhere between the two. The CRA will draw its conclusions after examining the facts and particular circumstances. “Determining whether a shareholder benefit has been conferred in any given case depends at least as much on the facts as on the law,” he says.
The CRA has already confirmed that the critical illness insurance amount is paid tax-free when the parties share ownership of the policy. Concerning the tax treatment of the ROP, the federal agency has commented only on non-shared policies, Dollar adds. “In the end, the only certainty appears to be that clients must get appropriate tax advice before creating a CII shared ownership arrangement,” he concludes.
The ultimate test looms
Stéphane Rochon, vice-president Sales and Marketing at Humania Insurance, has not taken an official stance on the shared premium concept. “Until we have an official opinion from the government on the best way to do this, we will not go ahead,” he says.
The greatest risk in this approach is impoverishment of the company, which may result from loss of coverage, Rochon points out. “A client with $500,000 in critical illness coverage cancels his policy after 15 years to recoup the return of premium. The next day, the company no longer has coverage in place. Has the executive enriched himself to the company’s disadvantage? This seems like an impoverishment of the company, but it’s not clear. We have all asked the Canada Revenue Agency for an opinion but we have not received anything firm. My comfort level is limited here,” Rochon admits.
Reasonable sharing of the premium is another concern. “Many of these policies are sold on the balance between the premium linked to the insurance cost and that of the return guarantee,” Stéphane Rochon explains. “If there is a balance, we can say it is correct in tax terms. But the first test will happen when the first returns of premiums are requested.” This should be imminent. “The first of these policies were sold 10 to 12 years ago, with a 15-year guaranteed return of premium at expiry.”
Nathalie Tremblay confirms that the 15-year test is approaching for policies at Desjardins Insurance. The insurer carved an enviable niche in this market. It has been promoting the product since 2003, which it dubs the Executive Health Savings Plan (EHSP). “We have not had any file challenged by the tax agencies to date. In several cases we have paid out a critical insurance benefit. We also have cases where the health benefit (return of premium) is soon payable. We will issue a reimbursement cheque for one case next month,” Tremblay confirms.
Not all cases result in return of premiums, she adds. “One of our shared ownership policies expired and the insured decided not to take the return of premium, extending the term of the policy instead,” Tremblay explains. “The return would have totalled $120,000, but the insurance coverage retained was $500,000. After all these years, the employee might have felt less invincible.”
Desjardins chose the Term 100 avenue, but Tremblay is not overly worried about the reaction of the tax authorities even if the high cost of this policy may impoverish the company from some standpoints. She explains that the insurer has done its duty regarding sharing of premiums
“We don’t make the company pay the entire Term 100 premium for the insurance risk,” Tremblay says. “For a shareholder age 50 who plans to retire at age 75, we provide Term 100 coverage but with a Term 75 premium (cost of protection until age 75, which is less expensive). If the employee plans to retire at age 65, we adjust the premium to a Term 65 (at a lower cost). We make sure the insured pays the premium for the return of premium plus the difference in price between the Term 75 (or Term 65) and the Term 100.”
Need above all
In the field, managing general agents consider it crucial that the cases they handle meet a real need for coverage of a key employee. It’s not only impoverishment of the company that’s important,” says Nancy Elkas, living benefits director at Financial Horizons Group. “The need for critical illness coverage is the top priority, and the needs analysis should justify the choice of insurance amount. For example, how much would it cost to replace the key employee or pay fixed costs, and for how long? What is the possible tax impact of shared ownership on the corporation? etc.”
Elkas rejects the “investment” approach seen in the industry. “Using this concept to tell clients that they can take money from their operating company tax-free is not the way I do things,” she says.
Need is a sensitive topic. This market niche first took off in the early 2000s with permanent Term 100 policies. Many feared a negative assessment by the tax authorities because these policies are very costly to companies compared with the real need for protection, which may not be permanent.
Claudine Cloutier, living benefits director at Groupe Cloutier Investments, stresses this point. “The market sold a lot of Term 100 early on even though the need to protect a key employee has a limited lifespan. If a client plans to work at the company until age 75, a Term 75 with a 15-year option for return of premium on expiry is much more appropriate” she says.
“I never recommend the advisor sell an accelerated pay permanent coverage, as a Term 100 payable in 10 or 15 years. The corporation will pay too much for the insurance coverage and the key person too little for the return of premium rider – around 5% to 10% of the overall cost – It’s too good to be true,” she says.
Cloutier sees a critical illness policy shared jointly with ROP as only one possible avenue for protecting a key employee in case of critical illness. The other frequent path is covering the insurance need only. “For a business, shared ownership does not change anything. The insurance need remains the same. This represents mainly an asset for the shareholder or executive,” she says.
Advisors leading the way
Brothers Alain and Jean Rondeau have been jointly serving this market with various carriers since the concept surfaced, Alain under the banner SFL Partner of Desjardins Financial Security in the Quebec City region, and Jean in Drummondville, Quebec through the firm Rondeau Services Financiers.
“Clients have obtained a ROPs (for clients) for varying amounts, like $120,000, $140,000, or $150,000. Each case showed that there was no impoverishment of the company because the shareholders were already being taxed on the benefit,” Jean Rondeau explains.
Under this plan, key employees must report a fair portion of the premium paid for the ROP rider as a taxable benefit. The shared ownership agreement must be clear on this point and specify the splitting of the premium between the company and its shareholder or key employee, the Rondeau brothers add.
The agreement must clearly identify the owner and beneficiary of each part of the policy. It must specify the beneficiary of the illness benefit, the health benefit and the death benefit (ROP at death). “Whatever the benefit the shareholders choose, they must be taxed on it each year,” Alain Rondeau says. “If they do not declare the benefit, it may be very costly. One client eligible for a $220,000 benefit under an old product didn’t report it. We told him to contact the CRA: turns out he owes $60,000 in taxes.”
The brothers emphasize that surrounding oneself with professionals who work in this niche is crucial. For example, Jean Rondeau mentioned that he consulted an accountant on all his cases.
Accountants can play a vital role here. “Consult an accountant to make sure the benefits are taxed properly,” the Rondeaus urge. Insurance products that identify and clearly separate the three benefits are rare, they add. The Desjardins product is one of the few that breaks the benefits down. The old product on which one of their clients has been taxed didn’t.
Products that allow separate accounts for each portion of the premium – the insurance portion and the return portion – are also scarce. Nancy Elkas could only think of one: the Sun Life product.