Dale Barrett and Simon Townsend of Barrett Tax Law.
Life insurance costs are costs that are usually borne by individuals that people do not consider a deductible cost.
With numerous deductions for losses on a business (or property) available in Canadian tax laws, it is possible, if not likely, that some opportunities will be missed. The opportunities that can be missed for income deductions, of course, go back to some of the most technical provisions of the Income Tax Act, RSC 1985, c 1 (5th Supp.) (ITA). One of these technical provisions is checked here: Paragraph 20 (1) (e.2).
This provision enables an individual or a company to deduct the reasonable cost of life insurance if it is used as collateral in a corporate finance contract. When would this be useful and why would it be overlooked? What else makes this provision so technical? This series tries to answer these questions and to clarify a technical determination in the ITA using a relatively simple example.
When would paragraph 20 (1) (e.2) make sense?
A company or one of its business units may have one or more key people – possibly executives or corporate rainmakers. A key person can be a technical person such as a researcher or a chief technology officer.
What these people have in common is that their death would prove detrimental to business. Therefore, it is common for a company to take out insurance against the loss of someone who is an integral part of its business or who may be difficult or impossible to replace. This insurance consists of a life insurance policy that is commonly referred to as “key person insurance”.
Unlike “dead peasant insurance” (insurance taken out by companies for the lives of low-wage workers – usually without their knowledge), key person insurance is designed to mitigate the losses a company would suffer if a key person died. It allows the company to use the payout to find a replacement or give the company a chance to get back on track.
Aside from their direct value to the company, many key employees have value to financial institutions, who often agree to fund a company based on their trust in that person and their value to the company. Under a financial arrangement based in part on a person’s merits, qualifications, or experience, the lending institution may request collateral to compensate if something happens to that person.
The key person insurance can then be taken out by the company and used as security in the loan agreement, or an existing life insurance policy can be taken out. This protects the credit institution from something that happens to the individual, the merit of which ensures the continued repayment of the loan.
In such a case, paragraph 20 (1) (e.2) becomes a valuable tool for the borrower. The way it works is that this provision allows the borrower to deduct reasonable life insurance costs from their income, which in turn made it easier to finance with the lending institution.
From a tax perspective, life insurance that is assigned to a financial institution for income generation or that is specifically taken out to facilitate a business loan is different from a policy that is specifically taken out to mitigate the loss of a key person.
As the funds borrowed are used to generate income and a portion of life insurance has been assigned, the cost of owning life insurance has changed. Similar to all other reasonable expenses used to generate income, it is deductible in reporting at the end of each tax year, but only in accordance with paragraph 20 (1) (e.2) of the ITA.
In the case of an existing key person insurance, which then assigns this to a lender, the purpose of this insurance changes from a reduction purpose (which protects the company from the losses and the resulting damage, the death of a key person) to an income purpose.
This is part one of a two part series. Part two discusses why paragraph 20 (1) (e.2) may be overlooked and what makes the provision technical.
Dale Barrett is the managing partner of Barrett Tax Law, founder of Lawyers & Lattes Legal Cafe, author of Tax survival for Canadians and the editor of Handbook of Family Law and Taxes and columnist for The Lawyer’s Daily. He is also a frequent tax lecturer, especially for accountants. Simon Townsend is a student at Barrett Tax Law.
This article was originally published on the Lawyer newspaper. Image by Steve Buissinne from Pixabay.