LIFE INSURANCE POLICIES: Using Tracking Shares
When a shareholder passes away, their shares are deemed to be disposed of at fair market value (FMV) unless a tax-free rollover is available and used. This can cause a tax liability at a time when no cash is available. Holding a life insurance policy in the corporation in respect of the owner-manager can fund these tax liabilities or provide cash to buy out the shares from the estate.
In some cases, whole-life insurance policies are used as tax-sheltered investment tools. However, a problem may arise in that the FMV of the insurance policy is deemed to be its cash surrender value (CSV) for the purpose of determining the FMV of the shares of the corporation. In other words, obtaining such a policy potentially increases the gain experienced on the shares upon deemed disposition at death. Also, the insurance proceeds may not go to the desired party.
Insurance tracking shares can be used to address these issues. They are essentially shares whose value is directly attached to a policy’s CSV, death benefit, or both. They can be issued as preferred shares without access to voting rights, dividends from business profits, or participation in value growth of the rest of the business. If obtained at the initiation of the life insurance policy, the shares can be purchased for nominal consideration because the FMV of the policy should also be nominal. The insurance tracking shares could be redeemed after death, with the related dividend being tax-free by using the increased capital dividend account from the payout of the insurance policy.
As the policy increases in value due to the investments, so do the tracking shares, which would be held by the specific parties intended to benefit from the increases, such as the individual’s children. Two May 19, 2021, Technical Interpretations confirmed CRA’s 2005 position that the CSV would be allocated between the common shares and the insurance tracking shares based on the rights and attributes of each class, using the same valuation principles that would guide the allocation of the value of other corporate assets.
If done correctly, the proceeds of the common shares on death would not be affected by the increase in insurance policy value. However, it is important to note that a specialist should be used in setting up these shares as significant precision in the share attributes is required to ensure that it functions as intended.
ACTION ITEM: Holding a life insurance policy in a corporation can be a useful tool to assist with continuity upon death of an owner-manager. The use of insurance tracking shares can mitigate increases in capital gains upon death when using such policies.