Dealing with life insurance on a divisive reorganization

When business owners are shareholders of a corporation and decide to go their separate ways, they may need to transfer some of the corporate assets to a new corporation in a “divisive reorganization”. The Income Tax Act contains some very complicated rules for undertaking a divisive reorganization without incurring any tax. Some corporate assets, such as life insurance, are difficult to get out of a corporation in a tax effective manner.

In a recent CRA ruling (#2017-0714411R3), a farm corporation’s (Farmco) assets, including life insurance, were being split between a mother and her two children. After the reorganization Child 1 would retain Farmco. Child 2 and the mom would hold the shares of the transferee corporation (TCo).

The divisive reorganization rules deem siblings to be dealing at arm’s length. To break apart Farmco in a tax effective way, the Income Tax Act requires the classification of assets into specific categories and that each company have the appropriate percentage of each asset category after the reorganization. The CRA ruled that life insurance on the mom and child 2 would constitute “cash or near cash assets” up to the cash surrender value (CSV) of the policies and “investment property” for the excess of the fair market value (FMV) of the policies over their CSV.

Many assets can be transferred on this type of reorganization on a tax-deferred basis using section 85. Because life insurance is not “eligible property” for purposes of section 85, the transfer of a portion of the mom’s insurance and the insurance policy on child 2 could not rollover to TCo. Instead TCo had to give a promissory note for the FMV of the interest in the insurance policies it acquired which, on the facts here, would have resulted in proceeds of the disposition of the policies to Farmco at FMV under subsection 148(7). Although the figures were not provided in the ruling, there would have been taxable policy gains included in the ordinary income of Farmco for the amount by which the proceeds of the disposition exceeded the adjusted cost basis (ACB) of the policies. The ACB of the interests in the insurance policies acquired by TCo after the transfer would be set at the FMV proceeds.

When thinking about placing insurance in a corporation, it is important to consider whether it’s likely that the policy would have to be transferred in the future. If so, it makes sense to consider ownership by a different entity or person. Just as with a marriage breakdown, sometimes a future divisive reorganization cannot be foreseen. If a transfer does have to happen, it can result in big tax consequences.