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Stop-Loss Grandfathering Exceptions Under Subsection 112(3)-(3.32): Pre-Existing Insurance Rule
The stop-loss rules in subsections 112(3) to (3.32) of the Act apply to share dispositions and may reduce the loss on the sale of a share by the amount of tax-free dividends received on the share. If shares are redeemed following the death of an individual and corporate-owned insurance is used to fund the redemption price, the stop-loss rules may prevent the full loss from being carried back by the estate to offset the gain in the taxpayer’s terminal return. However, exceptions are available to alleviate the hardship caused by subsections 112(3) to (3.32). These exceptions, which are not found in the Act, are based on transitional rules that date from the coming into force of subsections 112(3) to (3.32).
The grandfathering exceptions—available for the 2000 and subsequent taxation years—are found in the Income Tax Amendments Act, 1997, SC 1998, c. 19, section 131 (“the 1997 amendments act”), as amended by the Income Tax Amendments Act, 2000, SC 2001, c. 17, section 251 (“the 2000 amendments act”). These two acts, which were published July 31, 1998 and June 14, 2001, respectively, are in the Canada Gazette, Part III: Acts of Parliament. Given how much time has since passed, a refresher on the grandfathering exceptions may be helpful.
Three of the original five grandfathering exceptions required a disposition before 1997 and are no longer available. The other two, which can be referred to as the “pre-existing agreement rule” and the “pre-existing insurance rule,” are found in paragraph 131(11)(a) and paragraph 131(11)(b) of the 1997 amendments act, respectively, as amended by the 2000 amendments act.
Pre-Existing Agreement Rule
The pre-existing agreement rule applies to a disposition that occurs pursuant to an agreement in writing made before April 27, 1995. What constitutes an “agreement,” while relatively straightforward, may be open to interpretation.
Pre-Existing Insurance Rule
The balance of this article relates to the pre-existing insurance rule. This rule is the more complicated of the two rules, and it applies when insurance proceeds are used to redeem shares. It requires that certain criteria have been met on April 26, 1995 and that different criteria be met on the date of redemption. The criteria for April 26, 1995 are as follows:
- The share was owned by an individual (other than a trust) or by a trust under which an individual (other than a trust) was a beneficiary;
- A corporation, or a partnership of which a corporation is a member, was a beneficiary of a life insurance policy that insured the individual or the individual’s spouse; and
- A main purpose of the life insurance policy was to fund a redemption, acquisition, or cancellation of the share by the corporation that issued the share.
While these three criteria take into account the share owner and the beneficiary of the insurance policy on April 26, 1995, the rule’s remaining criteria concern the identity of the owner on the ultimate redemption date. Specifically, the disposition must be made by
- The individual or the individual’s spouse or common-law partner;
- The estate of the individual or of the individual’s spouse or common-law partner within the estate’s first taxation year;
- The particular trust that owned the shares on April 26, 1995, if it is a post-1971 spousal or common-law partner trust or a pre-1972 spousal or common-law partner trust, provided that the disposition is made within the first three taxation years of that trust following the death of the individual’s spouse; or
- A spousal trust, an alter ego trust, or a joint spousal or common-law partner trust, provided that the disposition is made within the first three taxation years of that trust following the death of the individual or the individual’s spouse, as the case may be.
It should be noted that the persons listed here are not expressly limited to the individual or trust that owned the shares
on April 26, 1995. Notably, the redemption criteria effectively allow for share transfers between April 26, 1995 and the ultimate redemption date, although the possible transferees are limited to the spouse, the individual’s estate, the spouse’s estate, certain life interest structures, and spousal or common-law partner trusts (inter vivos or testamentary).
Consider, for example, spouses Blair and Alex. Blair owned 100 common shares of Cco on April 26, 1995. On Blair’s death, the shares passed to Alex pursuant to Blair’s will. Alex has recently died. On April 26, 1995, Cco was the beneficiary of a life insurance policy covering Alex and Blair, the main purpose of which was to fund a redemption of the shares.
If Cco redeems the shares now held by Alex’s estate within the first year of the estate, the second requirement listed above is satisfied. The ultimate redemption can be made by the estate of the individual who owned the shares on April 26, 1995, or by the estate of that individual’s spouse.
Therefore, the pre-existing insurance rule applies. The stop-loss rules in subsections 112(3) to (3.32) will not prevent the loss on share redemption from being carried back by the estate and applied in Alex’s terminal return to offset the gain on the disposition of the 100 common shares of Cco.
Changes to the Insurance Policy
Provided that the “main purpose” test was met on April 26, 1995, changes to the policy after April 26, 1995 may be possible. Such changes could include converting the policy to a universal life policy, replacing it with a new life insurance policy, increasing the death benefit, or adding a new life insurance policy with an additional death benefit. (See CRA document no. 2005-0124311E5, June 28, 2005.)
Share Exchange After April 26, 1995
Finally, because subsection 131(12) of the 1997 amendments act deems a share of the corporation acquired in exchange for another share in a transaction to which section 51, 85, 86, or 87 of the Act applies to be the same share as the other share, reorganizations after April 26, 1995 that rely on those provisions of the Act would not automatically disqualify the shares. Were it not for this relieving provision, the ownership requirements on April 26, 1995 could not be met if a share exchange occurred after April 26, 1995.
Practitioners dealing with the pre-existing insurance rule should keep the 1997 amendments act and the 2000 amendments act close at hand. It may be useful to undertake a step-by-step analysis similar to the one shown above, even to the point of reproducing the 1997 amendments act, as amended by the 2000 amendments act, and inserting the names of the parties and shares as appropriate.