It is common for business people to have their corporation act as owner and beneficiary of their life insurance policy. In doing so, the corporation is permitted to pay the premiums for that policy and collect the life insurance proceeds tax-free.
Although in most cases the premiums are not deductible to the corporation, there is often a significant tax advantage to having the corporation pay the premiums. If the premiums are paid by the individual, they are paid with after-tax personal dollars, whereas if they are paid by the corporation, they are paid with dollars that were taxed inside the corporation at a lower tax rate.
Once the insurance proceeds are received, they are not taxable to the corporation and an amount equal to the proceeds (net of any adjusted cost basis) is added to the corporation’s capital dividend account. These funds can then be paid out tax-free to Canadian resident shareholders as a capital dividend.
What happens when there are no Canadian resident shareholders to receive the tax-free dividend?
Take for example parents who, while their children were young, purchased a last to die life insurance policy through their holding corporation. Since the insurance proceeds were ultimately meant to benefit their children, the last will and testament of the second parent to die left all the shares of the company to the children. The problem is that the children have all moved to the United States and are no longer Canadian residents (all too common these days).
Not only will there be U.S. tax issues to consider, there will also be Canadian tax to pay when the life insurance proceeds are paid out as a dividend to the U.S. resident children. If the parent simply owned the life insurance personally and the proceeds were received by their estate, the distribution from the estate to the U.S. resident children would have been tax-free!
If the recipient of the life insurance capital dividend is a non-resident of Canada, the recipient is subject to Canadian withholding tax equal to 25% of the gross amount of the dividend (reduced if the recipient of the dividend is resident in a country that has an Income Tax Treaty with Canada). In our example, since the U.S. has a tax treaty with Canada, the corporation would be required to collect and remit 15% of the proceeds to the Canadian tax authorities before distributing anything to the U.S. resident children. It is important to note that even though the estate of the parent is Canadian (and the dividend is first being paid to the estate), there are certain provision in the Income Tax Act that deem the distribution from the estate to be income to the beneficiary, subject to withholding tax (as opposed to capital, which is not subject to withholding tax).
The tax treatment in the U.S. of the receipt of the life insurance proceeds depends on various factors, including whether or not the corporation that received the proceeds is considered under the United States Internal Revenue Code (the “Code”) as a Controlled Foreign Corporation (“CFC”). In our example, since the children are U.S. residents and they are the heirs of the estate which owns all the shares of a Canadian corporation, U.S. rules deem the children themselves (and not the estate) to own the shares. The result is that the corporation will be considered a CFC.
Until the enactment of new amendments to the Code in 2017, there was some uncertainty among U.S. practitioners as to whether foreign life insurance proceeds received by a CFC and paid out to U.S. shareholders was taxable to the shareholders. However, the amendments introduced a new type of “catch-all” income category called “GILTI” which many U.S. practitioners feel encompasses such proceeds. Accordingly, since the U.S. children are deemed to own the shares of the CFC at the time the life insurance proceeds are received by the corporation (and the life insurance proceeds constitute GILTI), the children would likely be subject to U.S. tax.
However, there are some simple tax strategies that can be implemented before the death of the parents to avoid the ultimate imposition of U.S. tax. While an in-depth analysis of these options is beyond the scope of this article, one way to potentially avoid any tax issues relating to CFCs is to convert the corporation into a Canadian Unlimited Liability Company (“ULC”). A Canadian ULC is not treated as a corporation for U.S. tax purposes (and therefore by definition is not a CFC), and, as such, all the assets of the ULC are deemed to be owned directly by their shareholder. Thus, any income or loss realized by the ULC (i.e. the life insurance proceeds) will be treated as being realized by the owner of the ULC directly (being the Canadian resident estate of the parent).
If you own life insurance in a corporation and the ultimate beneficiaries of your estate are not residents of Canada (or they are thinking of leaving Canada), steps should be taken now in order to avoid potential unexpected tax consequences. Our attorneys can help you determine whether the short-term tax savings outweigh the potential long-term tax cost.