Life insurance owned by a trust

What are the tax implications if a policy is transferred out to a trust beneficiary?

The BMO Insurance specialized Advanced Markets Team regularly receives questions regarding individual and corporate solutions for high-net-worth clients. This month, an advisor reached out wanting information on life insurance owned by a trust. Here’s what our resident tax expert had to say.  

Overview

Acknowledging that trusts can easily differ from one another in significant ways, Canada Revenue Agency (CRA) has previously identified (though not always conclusively commented-on) important tax considerations involved in transfers of trust-owned insurance.  

Some relevant tax considerations include (but are not limited to): 

• The connection between a trust’s corporate (share)holdings and corporate beneficiaries;
• Who are the life policy’s “insureds” and who are the policy’s beneficiaries; 
• Any application of income attribution rules, including 75(2) of the Income Tax Act which can “block” the applicability of a s.107(2) rollout; 
• If any consideration – or promise of consideration – is bestowed on the trust as a result of the policy transfer; and
• If the trust is being used as a “conduit” to pass the life policy through the trust between related parties and/or connected corporations.

Another key consideration, of course, will be the actual determination as to whether the trust is transferring the policy to a related party, or if it is transferring to an arm's length third party.

Distribution to a Capital Beneficiary

Depending on the trust’s terms, a trust beneficiary may be able to receive income from the trust, receive the trust’s capital, or both.

With that in mind, consider that trust-owned policies may sometimes be distributed to a trust’s beneficiary on a tax-deferred basis. But how would that work? When would the distribution/disposition occur at the policy’s adjusted cost basis (ACB), instead of at its fair market value (FMV)?  

From its comments at 2024 Spring and Fall tax conferences, the CRA reconfirmed its previous position that where a personal trust:

• distributes an interest in a life insurance policy to its Canadian resident capital beneficiary, and
• does the transfer “in kind” as a full or partial settlement of that beneficiary’s capital interest

the trust would be deemed to dispose of and distribute the policy at its ACB, such that a tax-deferred transfer or “roll-out” is realized to that trust beneficiary.

See it in Action

To help illustrate how this works, consider the following scenario:

• The X Trust has one trustee, Y, and one Canadian-resident beneficiary, Z. 
  • In this scenario Z as both an income beneficiary and a capital beneficiary of the trust would, per Income Tax Act paragraph 251(1)(b), be deemed not to be dealing at non-arm’s length with the X Trust.
    
• X Trust owns assets that include:
  • an insurance policy of the whole-life variety that has a $700,000 cash surrender value (CSV) and a $300,000 ACB; and
  • $300,000 from income that was previously retained-and-taxed within X Trust.
    
• Y as the trustee of X Trust (and under the trust terms), distributes the trust-owned whole life policy to Z for no proceeds/consideration or promise thereof. Specifically:
  • The policy is disposed of by X Trust as a type of “distribution-in-kind” to Z;
  • X Trust makes the distribution in settlement of Z’s capital interest; and
  • Recall that there was already sufficient trust capital to satisfy/facilitate a $300,000 distribution in settlement of a capital interest.

Where Z receives the life policy as a capital beneficiary of the X Trust, subsection 107(2) of the Income Tax Act would apply such that X Trust will be deemed to dispose of the policy for proceeds equal to its ACB, i.e., $300,000. 

• As such, X Trust will have realized a tax-deferred roll-out of the policy to its capital beneficiary Z, who will be deemed to acquire the policy at the same $300,000 ACB amount.

What if the life policy was instead received in satisfaction of Z’s income interest in the X Trust? In that case, Income Tax Act subsection 148(7) – or Income Tax Act subsection 106 (3) – would apply such that that the non-arm’s length transfer of X Trust’s policy interest would be deemed to occur with “proceeds” set at FMV.  

• In the absence of any consideration from Z to the trust, the policy’s “disposition proceeds” should be at the policy’s CSV, i.e., $700,000. As such a policy gain of $400,000 would be realized by X Trust. As well, Z will be deemed to acquire the policy at the same $700,000 amount.

As always, please consult an experienced tax professional and trust planner/lawyer if you anticipate any transfer of trust-owned life insurance policies. This should not be taken as legal, tax, or financial advice. 

Disclaimer:

Information contained in this article is general in nature and should not be construed as legal or tax advice. You are encouraged to seek the advice of other professionals such as legal and tax experts. Please consult the appropriate policy contract for details on the terms, conditions, benefits, guarantees, exclusions and limitations. The actual policy issued governs. Each policyholder’s financial circumstances are unique, and they must obtain and rely upon independent tax, accounting, legal and other advice concerning the structure of their insurance, as they deem appropriate for their particular circumstances. BMO Life Assurance Company does not provide any such advice to the policyholder or to the insurance advisor. 

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