Some tax experts say change to 'surplus stripping' appears to target the capital dividend account, which is increased by the death benefit from a corporately held life insurance policy.Getty Images/iStockphoto
Small-business owners with life insurance held inside their corporations are concerned their policies may get caught up in Ottawa's proposed tax reforms. Some tax experts say the changes could significantly erode the value of some estates and potentially leave beneficiaries short, while others expect final legislation will be clarified to exclude these types of impacts.
One of the Liberal government's proposed changes, which is retroactive to the July 18 announcement, is to restrict the conversion of a corporate surplus taxable as dividends into lower-taxed capital gains, commonly referred to as "surplus stripping."
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Some tax experts say that change, as worded in the government's proposed legislation, appears to target the capital dividend account, which is increased by the death benefit from a corporately held life insurance policy. Under Ottawa's proposal, life insurance proceeds that normally flow tax-free to the estate could be taxable as a dividend, which would be at a rate of up to 45 per cent in Ontario, for example.
"This is big. This will affect so many businesses if they pass it through," says Milan Topolovec, president and chief executive officer of Ottawa-based TK Financial Group. "Thousands of corporations have ownership in policies with proper design and they would all have to be changed or be taken out of the corporation."
If the payout is taxed in this way, Mr. Topolovec says it could leave some estates short and beneficiaries, including family members or business partners, scrambling to cover the gap.
"It's like being underinsured," he says.
While that could benefit insurance companies, if business owners look to buy more coverage, Mr. Topolovec says it's not fair to his clients.
"I don't want to benefit that way," says Mr. Topolovec, who also owns corporate insurance in his business.
It also assumes business owners can increase their insurance, which he says may not be possible if they have health issues or participate in risky sports.
Ian Pryor, president of Pryor Tax Law, says clients are calling his offices in Ottawa and Toronto confused about whether their policies are affected and how to react, if at all.
"It's causing great complexity and uncertainty for our clients," Mr. Pryor says. "Even the tax community can't even agree on what [this proposal] applies to and what it doesn't."
He cites an example of a business owner in Ontario with a $1-million life insurance policy inside their corporation taken out to help support family members, pay tax, pay the mortgage and put kids through university in the event of his unexpected death. Before the legislation was put into effect on July 18, a significant portion of those funds could be paid out tax-free. If the new rules stick and apply to this scenario, the $1-million policy would be taxed as a dividend at up to 45 per cent when paid out, leaving roughly $550,000 for beneficiaries.
"That could have dire results for estates," Mr. Pryor says.
While the proposals don't appear to target corporately owned life insurance, the concern is that it could be captured in the changes, says Kevin Wark, a tax consultant for the Conference for Advanced Life Underwriting (CALU), which represents financial advisers, accounting, tax, legal and actuarial professionals.
"We don't think that's the intent, so our role is to try to clarify that," Mr. Wark says. He says CALU is talking to its members about the possible effects of the proposals and has joined other organizations from across Canada to form the Coalition for Small Business Tax Fairness, to oppose Ottawa's tax changes.
In an interview with The Globe and Mail's editorial board on Wednesday, Finance Minister Bill Morneau was asked about the potential impact his government's proposed tax changes could have on corporate life insurance policy holders.
Mr. Morneau said the government is listening to the feedback "to make sure we're not having unintended consequences.
"I haven't seen all of them to know which ones have really significant potential for a challenge but as we do we'll look at them and make sure if there's an issue, if there's a change, that it was an intended change and not an unintended issue that has come up. I'm sure there will be things that we'll need to address."
Jamie Golombek, managing director of tax and estate planning at CIBC Wealth Strategies Group, says it appears the government is listening and may be open to changing the proposals where there could be unintended consequences.
"I don't think that's the intention at all of these rules," Mr. Golombek says of the concerns around the capital dividend account. "I'm not overly worried about that. I think that will be fixed."
Mr. Golombek believes a bigger concern could be whether corporate life insurance will be caught in proposals, still being developed, that would restrict the use of incorporated small businesses as a vehicle for making passive investments.
"What we don't know is how that proposal, if it goes forward, will be applied," Mr. Golombek says. "If you make money in the corporation and don't reinvest in the business, but instead invest in a corporately owned life insurance policy, is that considered to be used in the business? Or not?
"Hopefully that won't be an issue, but our role is to raise the issues and hopefully get them sorted out."
If that change were made around passive investments, Mr. Golombek says business owners would need to work with tax and insurance professionals to figure how to carry life insurance.
"You may conclude that life insurance is better owned on a personal basis than on a corporate basis," he says.