There’s a strategy used by some companies with their key personnel called (commonly) Split-Dollar Critical Illness Insurance. In theory, it provides key person critical illness protection for the business, as well as funding an asset transfer of some kind to that key individual in the future. The following article is a fairly technical look at the concept, along with the potential risks from a taxation standpoint. If you have any questions about whether this kind of strategy would be appropriate for your business, give me a call.
Shared ownership of critical illness policies: uncertainty prevails
by Alain Thériault, The Insurance & Investment Journal
The Canada Revenue Agency (CRA) has yet to confirm in which situations split-dollar critical illness policy benefits will be considered taxable or not. The CRA might consider such shared premiums policies to be taxable if it impoverishes a company and enriches an insured key shareholder. Advisors who sell this solution are walking on eggshells.
Shared ownership policies in critical illness insurance are intended to protect a company in the case where a key person, often the main shareholder, must take leave due to a critical illness. Under this financial solution, the company and the employee jointly hold the critical illness insurance policy. The company pays the insurance premiums and receives the benefits if the key employee falls ill. The key employee pays the premium for the return of premium benefit, which he receives if he does not contract an illness by the end of the period foreseen by the guarantee.
Would this return of premium impoverish the company in favour of the key shareholder? The question has remained unresolved for several years. There is no jurisprudence in this area, nor any decision by the CRA. Nothing that could determine what could or could not induce impoverishment of a company. Nothing to reassure the key shareholder, who might be required to pay federal taxes on the benefit.
Advisors have been acting prudently with their entrepreneurs clients, and insurers’ tax specialists are very cautious as well. Asked to comment on the taxation status of shared ownership premium policies, tax specialist Jocelyne Gagnon told The Insurance and Investment Journal that the situation has not changed since 2013, when the Conference for Advanced Life Underwriting (CALU) published an article on this topic.
Gagnon, vice-president, Planning Services – Quebec for PPI Advisory, adds that advisors specializing in businesses are still underwriting these policies. “Advisors have to make their clients aware of the potential risk of a contribution from the CRA, and write up a formal agreement.”
Preventing the worst
She explains how to maximally counter the appearance of impoverishing the firm. “There are extremes. Taking out coverage for a key person underwritten at an insurance cost of up to 100 years is risky because that person will not work until age 100. It is better to take term coverage that ends at age 75. You should not choose coverage that is not appropriate for the expected protection period for the key shareholder.”
The insurance premium that a company will pay for coverage that ends at age 100 is more costly than for T75 coverage. Even the best precautions may not suffice. Published in 2006, the most recent CRA tax interpretation bulletin has puzzled the industry for over 10 years. This bulletin states that the CRA may confer a taxable benefit on the shareholder regardless of the market value of the premium refund rider. This means that a T75 policy will not guarantee that the CRA will conclude that there is no impoverishment, even if it is less costly for the shareholder’s employer than a T100 would be.
To be prepared in case the CRA pay a visit, PPI recommends that its advisors meticulously document the transaction between the shareholder and the company. In addition to writing an agreement, the parties involved should keep a copy of the notice of premium, of the bills that the shareholder submitted to the company, along with reimbursement cheques, PPI explains in an information document.
One of the rare specialized articles on this topic was published in 2013 by CALU. Stuart Dollar, director, Tax, Wealth & Insurance Planning Group at Sun Life Financial, covered some shared ownership arrangements that he considers less risky than others.
Dollar took the example of a renewable T10 policy. The shareholder retires 20 years after the policy is issued, and leaves the company. The CRA does not necessarily conclude that the company is impoverished even if the shareholder receives a refund higher than the premiums paid, he says.
“While the Corporation will lose its CII coverage on the shareholder, it no longer needs it, and will no longer have to pay premiums. Further, the value of the insurance coverage has been consumed with the ending of the time period for which the coverage was provided, and the corporation is paid for the coverage in the most economical way,” Dollar adds.
A different interpretation
The interpretation may be very different in the case of a critical illness policy payable in 10 years that covers the shareholder for life. Five years after the end of premium payments, the shareholder remains insured but the parties decide to end the policy. The shareholder continues to work for the company. “Since the shareholder intends to remain working for many years, the insurance need still exists. In this example, cancelling the coverage may work to the corporation’s financial detriment. If that’s the case, there is a risk that the CRA could say that the corporation has conferred a shareholder benefit on the shareholder,” Dollar suggests.
He adds that the CRA draws its conclusions after having examined the particular facts and circumstances of the agreement between the corporation and its shareholder. “Determining whether a shareholder benefit has been conferred in any given case depends at least as much on the facts as on the law.” As a result, it is “more important than ever to ensure that clients considering the CII shared ownership strategy get appropriate tax advice,” he concludes.
Many advisors are wondering what will happen when shareholders insured under these policies become eligible for a return of premium, which generally occurs 15 years after issue. With the first policies having been issued in the early 2000s, the moment of truth is nearing.