CALU REPORT

JUNE 13, 2007

Charitable Giving & Life Insurance

The charitable applications of life insurance speak directly to its socio-economic value and, as importantly, the value of those who advise as to the solutions offered through the constructive applications of this historic product. Through preferential tax treatments, governments encourage support to worthy causes and organizations and recognize the dynamic that initiates and sustains these charitable forces.

This article by Kevin Wark of PPI Financial Group refreshes the traditional applications of life insurance in the cause-related context of giving and identifies innovative planning opportunities in a new age of donor-centric marketing.

Table Of Contents

• Introduction
• The Basics
• Traditional Gifting through Life Insurance
• The Revolution Begins
• Conclusions
• Endnotes
• About the Author

Introduction

The area of insurance and charitable gifting was once a sleepy backwater where there were but a few tried-and-true strategies and little innovation. However, the past decade has witnessed significant changes in the tax rules governing charitable gifting. This in turn has opened the door to new planning strategies involving life insurance. These strategies can create significant tax and estate planning benefits for those individuals who want to make meaningful charitable gifts. This article will review the “evolution” of the tax rules governing charitable gifting and the resulting “revolution” in planning opportunities using life insurance.

Copyright the Conference for Advanced Life Underwriting, June 2007

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The Basics

Individual Donors

Individuals who make donations to charities can claim tax relief through a series of tax credits.[1] A federal credit of 15.5% is available for annual gifts of $200 or less, with the credit increasing to 29% for annual gifts in excess of $200.[2] The value of the gift is increased by provincial tax credits. For example, if the provincial rate is 50%, the basic credit is worth 22.75% and the credit on contributions in excess of $200 will be worth approximately 45.5%.

Total annual gifts eligible for the tax credit cannot exceed 75% of the donor´s income in the year.[3] Any excess gifts can be carried forward and claimed in the following five years (again subject to the 75% income limitation).[4]

Gifts made in the year of death (through the deceased´s will or otherwise) can be claimed against 100% of income in that year. If there is insufficient income to fully utilize the credit, such gifts can be carried back and claimed in the year prior to death. Any gift that cannot be claimed in those two years will expire.[5]

Corporate Donors                                                                                   

The shareholder of a private corporation may choose to structure a charitable gift through his or her company. The company will be allowed to claim a deduction for the gift, subject to a limit of 75% of the corporation´s income in the year.[6] Thus, if the corporation is paying tax at the small business rate, the deduction will generally be worth less than the value of the credit to an individual donor. However, to the extent that the corporation has income subject to tax at higher corporate rates (in the range of 40-50%), the deduction will deliver similar tax savings at the corporate level to a gift by an individual donor.

Copyright the Conference for Advanced Life Underwriting, June 2007

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Traditional Gifting through Life Insurance

Individual Donors

Life insurance is a very effective tool for providing funds to a charity on the death of the donor. There are several ways to structure a gift of life insurance, with different tax consequences to the donor. This section will review the two main ways of structuring a gift of life insurance, and discuss how recent tax changes impact the attractiveness of each method.[7]

(a) Ownership of Policy by Charity

Until recently the most common way of structuring a gift of life insurance was to set up the charity as the owner of the insurance contract. The charity would direct the donor to pay the premiums under the contract, and would designate itself as beneficiary. On the death of the donor the insurance proceeds would flow to the charity as beneficiary of the policy.

Under this arrangement the donor can claim a credit for premiums paid under the contract after it has been transferred to the charity.[8] However, there is no credit available to the deceased´s estate upon the payment of the death benefit. As well, the donor gives up control of the insurance policy to the charity. If the donor has a change in circumstances (or change of heart), his or her only recourse would be to stop paying premiums under the policy. From the charity´s perspective, if the donor stopped paying premiums, it would have to decide whether to continue premium payments or surrender the policy for any cash surrender value.

When setting up this kind of gift, depending on the circumstances of the charity, it may be appropriate for the donor to provide the charity with a direction to hold the insurance policy and any substituted property for 10 years after the last premium payment has been made. This will remove the premium payments from the annual disbursement quota of the charity.[9]

(b) Gift of Insurance Death Benefit

Under this arrangement the donor purchases and retains ownership of the life insurance policy. An individual donor can designate his or her estate as beneficiary of the policy, and then arrange through his or her will to gift the insurance proceeds to designated charities. Tax changes introduced in the 2000 Federal Budget now allow an individual donor to designate one or more charities directly under the insurance policy as beneficiary of the policy.[10]

While the individual is alive there is no credit available for the payment of the insurance premium. However, on death the gift through the donor´s will[11] or via an insurance beneficiary designation[12] is treated as a donation in the year of death. As a result, a credit may be claimed in the deceased´s final tax return that can offset taxable income in that year. To the extent there is a charitable credit in excess of the deceased´s terminal return income, the remainder can be carried back and claimed against the deceased´s income in the year prior to death.[13]

The benefit of this type of arrangement is that the donor retains control of the policy and can change the beneficiary (either through the insurance contract or by amending the will) in the event there is a change in financial circumstances or a change in charitable intent. The disadvantages of this method is that there is no current credit allowed for the premiums paid on the policy, and depending on the size of the death benefit and income of the deceased, the full amount of the credit may not be utilized. While an important consideration, this latter concern has been minimized due to the increase of the annual limit to 100% of net income in the year of death, with a carry back to the deceased´s prior taxation year for any unused credits.

It should also be noted that where the gift flows through the donor´s will, the insurance proceeds will become subject to probate taxes and other estate administrative charges, as well as becoming subject to the claims of the deceased´s creditors. As a result, it is preferable to structure the gift through a revocable beneficiary designation.

Corporate Donors

Where the potential donor is also the owner of a private corporation, there may be benefits to structuring the gift of insurance through the corporation rather than personally. For example, assume that the shareholder is considering the purchase of an insurance policy to fund a $500,000 gift on death. The shareholder owns shares in a private corporation whose income qualifies for the small business deduction. The shareholder is in a 45% tax bracket and the corporation qualifies for the small business deduction and is paying corporate tax at a combined rate of 18%.[14]

Since the charity is not the owner of the policy, the premium payable on the policy will not be deductible, whether paid by the shareholder or the corporation. If the individual needs to draw additional salary from the corporation to pay the premium, he or she must receive approximately $9,100 to net $5,000 after tax. On the other hand, if the corporation pays the premium, it only needs to earn $6,100 (at an 18% tax rate) to net the required premium of $5,000. Thus, where the corporation pays tax at a lower effective tax rate than the shareholder, it is “cheaper” for the corporation to pay the premium on the policy.

It is also important to consider the tax consequences arising from the gift on the death of the shareholder. If the shareholder owned the insurance and designated the charity as beneficiary, the donation could offset up to $500,000 of income in the year of death and immediately preceding taxation year. However, if the shareholder did not have $500,000 of cumulative income in those two taxation years, a portion of the tax credit would be lost.

If the insurance proceeds are received by the corporation and donated to the charity, the donation can be claimed in the current year (subject to the 75% of net income limit) and any excess donation can be carried forward to offset corporate income over the next five years.[15] However, the value of the deduction may be lower if all of the corporation´s income is eligible for the small business deduction.

There is another significant benefit to setting up a private corporation as the owner and beneficiary of the insurance policy. The death benefit in excess of the adjusted cost basis (ACB) of the policy will be added to the capital dividend account (CDA) of the corporation.[16] This will permit the corporation to pay tax-free capital dividends to the surviving shareholders of the corporation in the future.[17] Thus, the gift of the insurance proceeds creates the dual benefit of a deduction against corporate income, as well as creating the ability to pay tax-free capital dividends to the surviving shareholders.

It should be noted that the rules that permit an individual to directly designate a charity as the beneficiary and claim the death benefit as a charitable gift do not apply to corporate donors.[18] As a result, if a shareholder wants to structure a charitable gift of insurance proceeds via a corporate owned insurance policy, proper provision must be made to ensure the donation is made as anticipated. This might include a unanimous shareholders agreement or giving instructions to the executor to authorize the corporate gift.

Copyright the Conference for Advanced Life Underwriting, June 2007

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The Revolution Begins

1. Gifts of Private Company Shares and Debt to Private Foundations

The 1997 Federal Budget introduced anti-avoidance rules to deal with the donation of certain shares or debt to a charity. Under these rules the gift of a “non-qualifying security” of the donor is deemed not to have been made unless the charity disposes of the security within five years of the gift.[19] If the charity disposes of the non-qualifying security the gift within the five-year period the gift will be recognized at that time. The fair market value of such gift will be the lesser of the consideration received by the charity and the fair market value at the time of the original transfer. If the charity does not dispose of the property within five years of the gift, the donation will be ignored for tax purposes.

Some donors have subsequently avoided the application of these rules by transferring private corporation shares into a trust in respect of which the charity is a beneficiary. A gift was recognized to the extent of the beneficial interest disposed of by the donor, while the property remained under the control of the donor through the donor´s control of the trust. The March 2007 Federal Budget has introduced additional proposals aimed at curbing these types of transactions by indicating that the same restrictions will apply as if the donor had donated the shares in his or her own name.

In circumstances where the donation is “deferred” by these new rules, the donor will be allowed a reserve for capital gains realized on the gift of the non-qualifying securities.[20] The donor is entitled to claim the reserve in taxation years ending within 60 months of the date of the gift. However, the reserve can no longer be claimed if the gift is recognized for tax purposes or if the donor becomes a non-resident or tax-exempt. If the gift is ultimately not recognized, the effect of the reserve is that no capital gain is realized on the transfer.

Non-qualifying securities are defined as an obligation of the donor or a non-arm´s-length person or partnership, a share of a corporation with which the donor does not deal at arm´s length or any other security issued by the donor or a non-arm´s-length person or partnership.[21] Obligations, shares and other securities listed on a prescribed stock exchange are excluded from the definition.[22]

Despite these new rules there remain a number of opportunities for owners of private corporations to in effect make gifts of debt and shares in their corporation and obtain an immediate tax benefit. These structures can be combined with corporate owned life insurance to further enhance the benefits of the gifting program. The following is a review of two of those opportunities:

a) Gifts on Death

Assume that the owner of a private corporation has completed an estate freeze and capital gains crystallization before 2007. As a result of these transactions the shareholder now has preference shares with a fair market value of $1 million and an ACB of $500,000. Under the shareholder´s will the preference shares are to be gifted to his private foundation. Assume further that the corporation acquires a T100 life insurance policy on the life of the shareholder for $1 million.

On the donor´s death the shareholder will be deemed to have disposed of the preference shares for $1 million, triggering a $500,000 capital gain and $250,000 income inclusion in the terminal return. The preference shares are transferred to the private foundation pursuant to the shareholder´s will and then redeemed by the corporation using the proceeds from the insurance policy.

Because the shares have been disposed of within five years of the gift, the deceased will be deemed to have made the gift in the year of death.[23] The estate will be able to claim a charitable credit of $1 million, which will not only offset the taxable capital gain on those shares but create an additional charitable tax credit that can be claimed against other income in the terminal return.

In addition, the private corporation will receive a credit to its CDA equal to the insurance proceeds less the ACB of the policy.[24] This will permit the surviving shareholders to withdraw up to $1 million from the private corporation on a tax-free basis.[25]

The net result is that the private foundation has $1 million in cash for charitable purposes, the shareholder´s estate can offset taxes on up to $1 million of income in the year of death, and the surviving shareholders can receive a tax-free distribution of $1 million from the private corporation.

b) Gift of Shareholder Loans

It has been a common planning strategy for owners of private corporations to bonus down corporate income to the small business deduction limit.[26] If the corporation requires funds for business purposes, the shareholder will lend the after-tax amount back to the corporation. Over time the shareholder loan amount can be quite significant and represents an asset to the shareholder and his or her estate.

Prior to the introduction of the rules governing the gifting of non-qualifying securities, the shareholder could formalize the shareholder loan by having the company issue a demand promissory note for the amount of the shareholder loan account. The shareholder could gift the promissory note to a charity and a charitable receipt would be issued for the full amount of the gift.

However, under the new rules this strategy will only be effective if the debt is repaid within five years of the gift being made. An alternative strategy would be for the corporation to borrow funds from a financial institution in order to repay the shareholder loan. The interest on such a loan should be deductible assuming the original shareholder loans were used for business purposes.[27] The shareholder could then donate part or all of the cash to their private foundation and obtain the tax receipt for the full amount of the gift.

As part of this gifting strategy, the corporation could also take out a life insurance policy on the life of the shareholder. If the financial institution requires the insurance as collateral security for the loan, then all or part of the premium would be deductible to the corporation.[28] In addition, on the death of the shareholder the insurance proceeds will be received tax-free by the corporation and can be used to repay the outstanding loan. The corporation would be entitled to a credit to its CDA to the extent that the death benefit exceeds the ACB of the policy.[29]

In summary, by using this strategy the charity will receive an immediate cash gift from the shareholder (funded by the repayment of the shareholder loan account). The shareholder can make the gift without any cash outlay and benefits from the charitable tax credit. The corporation now has external debt, and will be required to pay interest on such a loan as well as the cost of funding the insurance premiums. However, on the death of the shareholder the loan will be repaid and a credit to the CDA will be created.

2. Split Receipting Rules

It is possible to split the benefits and costs of a permanent insurance contract between two different parties. Under such an arrangement the parties to the arrangement would jointly own an exempt insurance policy and enter into a shared ownership agreement. Typically one party would have an ownership interest in the death benefit under the policy and be required to pay that portion of the premium attributable to the death benefit interest. The other party would have an ownership interest in the cash surrender value of the policy (and the death benefit attributable to the cash surrender value) and pay additional amounts to fund the growth of the cash surrender value.

These types of arrangements are often entered into where one party needs life insurance protection and the other party would like to take advantage of the tax-deferred growth of cash values within an exempt insurance policy. For example, parents and grandparents, shareholders and their corporations, or employers and employees might consider this type of arrangement.[30]

The shared ownership concept has been promoted as a way to structure a charitable gifting program. For example, the donor could enter into a shared ownership arrangement with a charity under which the charity is the owner and beneficiary of the death benefit. The donor would provide annual gifts to the charity to enable it to fund the insurance costs with respect to its interest in the policy. The donor would in turn own and fund the cash values of the policy, and could access those cash values (either directly through the policy or by borrowing against the policy) for business or personal reasons.

Under this arrangement the charity would ultimately benefit from the receipt of the insurance proceeds. Given this benefit to the charity, it was presumed that the donor would receive a tax credit for the cash gift to the charity (which in turn funds the base insurance charges under the policy) while also gaining access to the tax deferred growth under the insurance policy.

However, at common law, in order for a gift to be made, property must be transferred voluntarily with an intention to make a gift. Where the donor receives a “right, privilege or advantage” from making the gift, it is generally presumed that a charitable intention is not present.[31] The CRA has previously expressed the view that under a shared ownership arrangement a benefit is being conferred on the donor, and as a consequence no charitable credit can be claimed for the gift equal to the base insurance charges.[32]

However, the Department of Finance has introduced legislation[33] which provides that the existence of an advantage in respect of a property transferred to a registered charity does not “in and of itself” disqualify the transfer from being a gift if one of two conditions is satisfied:[34]

(a) the amount of the advantage does not exceed 80% of the fair market value of the transferred property, or

(b) the transferor establishes to the satisfaction of the Minister of National Revenue that the transfer was made with the intention of making a gift.

The “eligible amount of a gift” [35] will be equal to the fair market value the property being donated less the value of any advantage received by the donor. [36]

This draft legislation appears to open the door for the possible use of shared ownership arrangements with charities. The CRA was specifically asked this question and in a technical interpretation (TI) indicated:

“With regard to ‘split dollar´ or other shared ownership arrangements, it is possible that there may be arrangements that could result in a charitable gift for purposes of section 118.1 but such a determination can only be made on a case-by-case basis and we would need to review the particulars of a specific arrangement including all relevant agreements and the life insurance policy”.[37]

These proposals also require an evaluation of the value of the “advantage” being conferred on the donor under a shared ownership arrangement. The CRA had the following to say in another TI on this subject:

“To determine whether in a particular situation any portion of the premiums paid by an individual would qualify as a charitable gift, it would be necessary to demonstrate that this premium relates exclusively to the benefits under the policy that will accrue to the charity. Also, since there may be some cost reduction by virtue of having a single policy from what would be the premium obligation if two separate policies were used, it would seem that this saving should be taken into account. Therefore, absent a review of the particular arrangement, we are not in a position to confirm that the calculation of the amount of the gift, if any, is simply the excess of the annual premium over the cost of pure insurance for the year…”[38]

The donor and charity under a shared ownership arrangement should consider obtaining the services of an independent valuator to quantify the value of any advantage and determine the amount of the donation receipt that can be provided to the donor. If the value of the advantage cannot be ascertained, the CRA has indicated that the charity cannot receipt the gift.

3. Donation of Public Securities through a Private Company

One of the most recent and highly publicized tax changes affecting charities involves the preferred treatment applicable to the gifting of publicly traded securities[39] to a public charity.[40] Under the previous rules, individuals would be taxed at the normal capital gains inclusion rate (currently 50%) when these properties were gifted to any charity. However, the 1997 budget reduced the inclusion rate for qualifying gifts to one-half the usual rate where such gift is made to a public charity. This measure, originally intended to expire in 2001, was later extended indefinitely.[41]

The 2006 Federal Budget went one step further and eliminated capital gains tax on the gifting of publicly traded securities to a public charity. Public commentary has generally focused on the impact these budget measures will have on individual donors. However, there are significant gift planning opportunities in the corporate sector resulting from these proposals.

For the sake of illustration, assume that a married couple, Bob and Kathy, both age 65, own all the shares of a private Canadian corporation (BK Co.). BK Co. holds a portfolio of publicly traded securities valued at $5 million. Bob and Kathy would like to gift $1 million to their favourite charity. Rather than liquidating investments held by BK Co., paying the applicable tax and donating the after-tax proceeds, Bob and Kathy arrange for BK Co. to directly gift $1 million of public shares to the charity. Assume these shares have an ACB of $200,000.

In accordance with the new rules, BK Co. would not have a taxable capital gain on the gift of the shares. It would also receive a charitable receipt for $1 million, which would be available as a deduction to a maximum of 75% of its net income for the year. If the gift exceeded this limit, the excess may be carried forward and applied against the corporation´s income over the next five years. As BK Co. is subject to tax at a rate approximating 50% on its investment income, tax savings resulting from the gift would be almost $500,000.

There is, however, a significant additional tax benefit from the above strategy. As a private corporation, BK Co. is entitled to a CDA credit on the tax-free portion of any capital gains it realizes.[42] In this case, the entire capital gain ($800,000) is tax-free. This amount may be fully credited to BK Co.´s CDA and is eligible to be distributed to Bob and Kathy as tax-free capital dividends.[43]

If BK Co. does not have sufficient liquidity to pay a capital dividend to Bob and Kathy in cash, consideration should be given to paying the dividend in the form of a promissory note. This will effectively convert the CDA credit to a shareholder loan that may be paid down on a tax-free basis as cash becomes available in BK Co. from time to time. This will also reduce the value of the BK Co. shares for capital gains purposes, resulting in tax savings on the death of the survivor of Bob or Kathy.

There is an additional planning opportunity that presents itself in this case. In many situations, donors who make a substantial gift to a charity are concerned about the impact of the gift on the value of their estates. Life insurance can be used to replace the value of the gifted property, thus preserving the estate for benefit of surviving family members.

In this case, BK Co. could acquire a $1 million policy on the lives of Bob and Kathy with proceeds payable on the second death. BK Co. would also be the beneficiary of the policy and would pay the premiums. The proceeds would not only restore the value of the gifted shares on the death of the survivor of Bob and Kathy, but would also (net of the policy´s ACB) create a further CDA credit in the corporation. In this case, the credit would be available to surviving shareholders, presumably family members of Bob or Kathy. This cost of the policy could be at least be partially funded by the $500,000 in tax savings enjoyed by BK Co. on the original gift.

4. Charitable Annuity Programs

a) Traditional Programs

A charitable annuity typically involves the transfer of funds by a donor to a charity on the understanding that the charity will provide an income for life to the donor. These programs have been popular with older individuals as they don´t have to worry about managing their funds in order to obtain a “guaranteed” income stream for life.

The donor also benefited from preferential tax treatment on the income payments pursuant to a CRA administrative position.[44] Under this policy, to the extent the donor provided an amount in excess of the expected total stream of payments from the charity (as calculated by a life expectancy table set out in IT-111R2 ), the excess amount could be claimed as a charitable gift and all annuity payments from the charity would be tax-free.

For example, a male who is 65 years of age has an expected lifespan of 17.2 according to the life expectancy tables. If that individual donated $50,000 to a charity in return for annual payments of $2,400, all payments would be tax-free and the individual would be able to claim a charitable credit of $8,720 ($50,000 – (17.2 x $2,400).

If the donation was less than the expected amount of annuity payments from the charity, then each payment would consist of an equal blend of income and capital for tax purposes.

However, as a result of the introduction of the split receipting rules outlined above, the CRA has withdrawn its administrative position as outlined in IT-111R2.[45] In its place the CRA announced that where an amount is contributed to a charitable organization by a donor, and the advantage received by the donor is a stream of guaranteed payments for a period of time, the eligible amount will be equal to the excess of the amount contributed by the donor over the amount that would be paid at that time to an arm's-length third party (i.e. an insurance company) to acquire an annuity to fund the guaranteed payments.[46]

The CRA provided the following example to explain their new administrative position:

• A donor makes a $100,000 contribution to a charitable organization.
• The donor's life expectancy is 8 years (assume the donor lives 8 years).
• The donor is to be provided annuity payments of $10,000 per year ($80,000).
• The cost of an annuity that will provide $80,000 over 8 years is $50,000.

Tax treatment under prior administrative practice (IT-111R2):

• The donor receives a tax receipt for $20,000 for the year of donation.
• The donor receives in total $80,000 in annuity payments tax-free.

Tax treatment – New Position

• The donor receives a tax receipt for $50,000 for the year of donation.
• The donor receives in total $80,000 in annuity payments, of which $30,000 will be included in income over 8 years.

There are several issues resulting from this new administrative position. First, even if the charity is self-funding the annuity payments to the donor, the charity must “shop” the annuity market to determine what the comparable cost would be for an annuity producing a similar income as that being promised by the charity. Since the cost of such an annuity will vary between insurance carriers and will depend upon current economic conditions, this introduces a significant element of uncertainty and timing risk that did not exist under the prior administrative practice.

Next, the tax treatment of the annuity payments from the charity is now to be calculated using the life expectancy table prescribed under the Income Tax Act.[47] This table is more recent than the one prescribed by IT-111R2 and reflects favourable increases in life expectancy. This in turn will result in more tax being payable on the annuity income as a smaller percentage of each payment will be treated as a return of capital.

b) Charitable Insured Annuities

For the reasons discussed above, the “traditional” charitable annuity may no longer be as attractive as it once was to a potential donor.[48] Even prior to these changes there was a significant downside as the premature death of the donor would result in a significant loss of capital to the estate.

Where a donor wants to ensure the estate is not depleted as a result of the charitable gift, the capital can be returned to the estate through the purchase of life insurance. For older individuals (i.e. age 65+) it may be possible to structure such a program in a way that the individual maintains or even enhances his or her current cash flow on an after-tax basis.

For example, consider a prospective donor (male) who is 66 years old, in a 45% tax bracket and has $500,000 invested in T-Bills earning 4.5%. The individual is retired and is using the after-tax income of $12,375 to help cover living expenses.

One option for the donor to consider is to convert the $500,000 currently in fixed income investments into a “prescribed” life annuity with no guarantee.[49] The individual will receive a higher after-tax cash flow as each payment is considered to be a level return of capital and income for tax purposes. The individual also benefits from longer term interest rates and an enhanced pricing at older ages due to the nature of the annuity contract.[50] A portion of the after-tax annuity income is then used to purchase an insurance policy on the life of the donor.

The donor has several options under this structure to make a gift to a charity, depending on their income and estate planning needs.

Option 1 – The donor would use a portion of the annuity income to purchase a $500,000 insurance policy on his life. He would also make a donation to the charity equal to the taxable portion of the annuity payments. This will create a charitable credit that will offset the taxes on the annuity income. The donor still has a higher after-tax income even after making the charitable donation. As well, on the death of the donor the original $500,000 of capital is available for estate distribution.

Option 2 – The donor again uses a portion of the annuity income to purchase a $500,000 insurance policy on his life. However, he does not donate any annuity income to the charity. Instead, he uses the remaining additional cash flow to purchase another insurance policy and designate the charity as the beneficiary of the policy. Thus, while alive the donor´s cash flow remains the same as if he continued to own the fixed income investments, but he is able to make a significant gift on death to the charity through life insurance funded by the additional cash flow.[51]

c) “Stranger Owned” Charitable Annuities

There has been interest in Canada in using the tax advantages of the charitable annuity concept on a more structured basis within charitable organizations. A detailed review of these programs is beyond the scope of this article, but an overview of the structure and potential issues are worthy of some comment.

Under these programs the charity identifies a number of older insurable individuals (referred to as the “insured”) with an affiliation to the charity (including donors and volunteers). The charity then approaches a number of wealthy donors (referred to as the “donor”) with the idea of pairing the donor with an identified insured. The donor will commit an amount of money (say $250,000) and the insured is underwritten for this amount of insurance. Assuming the policy is approved on a standard basis, the donor then uses the $250,000 of capital to purchases an annuity as well as an insurance policy with a face amount of a similar amount.

The donor receives regular payments under the annuity and uses the annuity income to fund the tax on the annuity payments and pay the insurance premium. The donor then utilizes part or all of the remaining funds to make a charitable donation to the charity. The donor benefits from the charitable credit while the charity has an additional stream of donations that will continue as long as the insured is alive. This program may also be combined with leveraging to create interest expense deductions to the donor.[52]

There are several concerns with respect to these programs. First, depending on the overall tax benefits to the donor the charity may need to be concerned with the tax shelter rules contained in the Act.[53]

Second, the donor must ensure that there is complete disclosure of any health risks on the insurance application or the insurer could refuse to make the expected insurance payment on the death of the insured. Also, if the insured commits suicide within a certain period of time after the insurance policy is issued, the insurer has a contractual right to not pay the death benefit.

From an insurance company´s perspective, there is a lack of insurable interest that could result in the donor benefiting from the premature death of the insured. The insurance companies are also concerned that the insureds und, er the program may not be aware that by participating in this type of program, they could be negatively impacting their ability to obtain life insurance in the future.

Given the various issues surrounding “stranger owned” charitable annuities, advisors should be very cautious about becoming involved in arranging these types of programs.

Copyright the Conference for Advanced Lif, e U, nderwrit, ing, June 2007

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Conclusions

The ongoing changes to the tax rules governing gifts to public and private foundations have created additional complexity for donors and charities alike. However, these changes have also resulted in a number of new planning opportunities that can significantly enhance the estate planning of wealthy donors and shareholders in private corporations. The unique financial attributes of life insurance allow it to play a key role in enhancing planned gifting strategies and creating additional tax benefits in the context of a corporate donor.

The Conference for Advanced Life Underwriting, June 2007

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Endnotes

[1] These rules are set out in section 118.1 of the Income Tax Act, RSC 1985, c. 1 (5^th Supp.), as amended (herein referred to as “the Act”). Unless otherwise stated, statutory references in this article are to the Act.

[2] Subsection 118.1(3) of the Act.

[3] Definition of “total gifts” as set out in subsection 118.1(1).

[4] The limit was 20% of net income before 1996, 50% of net income for 1996 and 75% of net income commencing for gifts made in 1997.

[5] Subsections 118.1(4) and (5). It should also be noted that if a large charitable gift is made in the year of death there is a strong likelihood that the resulting charitable tax credit will exceed taxes payable in the year of death. The main reason for this is the deceased´s income will be subject to tax at an average rate that is below the top federal marginal rate, while the charitable tax credit is set at the top federal rate once donations exceed $200. Thus, the ability to carry back any excess charitable credits to the prior tax year can be very important in terms of utilizing the entire charitable tax credit.

[6] The rules governing charitable gifts by corporations are set out in section 110.1.

[7] See Interpretation Bulletin IT-244R3 dated Sept. 6, 1991 (“Gifts by Individuals of Life Insurance Policies as Charitable Donations”) for the Canada Revenue Agency´s (CRA) administrative position on gifts of life insurance.

[8] If the policy being transferred has a cash surrender value, the charity may also provide a receipt equal to the cash surrender value. This is also a disposition of the policy and the donor will have to report any policy gains as determined by subsection 148(1).

[9] Disbursement quota is defined in subsection 149.1(1) of the Act. Also see paragraph 6 of Interpretation Bulletin IT-244R3 (supra note 6).

[10] Subsections 118.1(5.1) and (5.2).

[11] Subsection 118.1(5).     

[12] Subsection 118.1(5.1)

[13] Supra note 5.

[14] Section 125.

[15] Definition of “charitable gifts” in paragraph 110.1(1)(a).

[16] Definition of capital dividend account in subsection 89(1).

[17] Subsection 83(2).

[18] There is no similar provision to subsection 118.1(5.1) for corporate donors.

[19] Subsection 118.1(13). These rules also apply to corporate charitable gifts by virtue of subsection 110.1(6).

[20] Subsection 40(1.01).

[21] Subsection 118.1(18).

[22] Some donors have subsequently avoided the application of these rules by transferring private corporation shares into a trust in respect of which the charity is a beneficiary. A gift was recognized to the extent of the beneficial interest disposed of by the donor, while the property remained under the control of the donor though the donor´s control of the trust. The March 2007 Federal Budget has introduced additional proposals aimed at curbing these types of transactions by indicating that the same restrictions will apply as if the donor had donated the shares in his or her own name.

[23] Subsection 118.1(15).

[24] Supra note 17.

[25] Supra note 18.

[26] Supra note 14.

[27] Paragraph 20(1)(c).

[28] Where the requirements of paragraph 20(1)(e.2) are satisfied, the corporation could deduct the lesser of the premium paid and the net cost of pure insurance for the policy.

[29] Supra note 17.

[30] Depending on the parties to the arrangement and how the shared ownership arrangement is structured there may be a number of tax and legal considerations which are beyond the scope of this article.

[31] See paragraph 3 of Interpretation Bulletin IT-110R3 and paragraph 1 of Interpretation Bulletin IT-244R3 – “Gifts by Individuals of Life Insurance Policies as Charitable Donations”.

[32] See CRA TI 9335905 dated June 6, 1994.               

[33] Bill C-33 which contains the enacting legislation for these proposals received second reading in the House of Commons on May 17, 2007. These proposals are to apply to charitable gifts made after Dec. 2, 2002.

[34] Proposed subsection 248(30).

[35] See definition of “charitable gifts” and “total charitable gifts” in subsections 110.1(1) and 118.1(1) respectively. Also refer to the definition of “eligible amount of gift” in subsection 248(31). See also CRA Technical News No. 26, dated Dec. 24, 2002, for the CRA´s interpretation of the split receipting rules.

[36] Rules defining the amount of any advantage arising from a charitable gift are set out in subsections 248(32) and (33).

[37] CRA TI 2003-0004315 dated June 6, 2003.

[38] CRA TI 2003-0004115 dated June 2, 2003.

[39] Publicly traded securities are defined in section 38(a.1) to include a share, debt obligation or right listed on a prescribed stock exchange, units in a mutual fund and units in a segregated fund policy.

[40] The 2007 Federal Budget proposes this treatment be extended to private foundations for gifts made after March 17, 2007. However, to prevent improper dealings between the shareholder, private foundation and the corporation, the foundation and non-arm´s-length persons must meet certain conditions in terms of overall share ownership or face penalty taxes.

[41]Subsection 38(a.1).

[42] Supra note 17.    

[43] Supra note 18.

[44] Interpretation Bulletin IT-111R2 – “Annuities Purchased from Charitable Organizations” dated Sept. 22, 1995 as revised Feb. 10, 1997 (archived).

[45] The position set out in IT-111R2 will continue to apply to charitable annuities issued prior to Dec. 21, 2002.

[46] CRA Technical News No.26.

[47] Subsection 300(2) of the Income Tax Regulations.

[48] As a simple alternative, the donor could purchase a prescribed annuity in order to create the required amount of income and gift any excess capital to the charity.

[49] The annuity payment is taxable under paragraph 56(1)(d), but a deduction may be claimed for the capital element of the payment under paragraph 60(a). The portion of interest and capital is fixed for each payment and determined by a formula established under Regulation 300 of the Act. The requirements for a prescribed annuity are set out in Regulation 304 of the Act.

[50] Another potential advantage for donors aged 65 years and older is the ability to split up to 50% of the annuity income with the donor´s spouse or common law partner as proposed in the Notice of Ways and Means Motion introduced on Oct. 31, 2006.

[51] Another option would be to have the second insurance policy owned by the charity with the donor paying the annual premium. This would result in a charitable credit that would enhance the after-tax cash flow from the annuity. However, the donor would not be entitled to a charitable credit when the insurance proceeds are received by the charity.

[52] The donor would liquidate investments to purchase the annuity and then borrow back funds secured by the annuity and insurance policy to purchase new investments. It should be noted that the Quebec Tax Act contains rules that generally limit the interest deduction to investment income earned in the year.