Are life insurance proceeds that fund a buy-sell agreement taxable in Canada?

There is no single yes or no, and none of the sections cited here says the proceeds are tax-free in those words. The Income Tax Act deals with the pieces separately: what happens when a corporation receives a death benefit, what happens when it pays that money out, and what happens to the premiums and the policyholder. Which section matters depends on who owns the policy and who receives the money. This page describes what each section does.

When the corporation receives the death benefit

Section 89(1) of the Income Tax Act defines a corporation’s capital dividend account. Paragraph (d) of that definition adds the amount by which the proceeds of a life insurance policy (other than an LIA policy) received by the corporation in consequence of the death of any person exceed amounts that include the adjusted cost basis, as defined in s.148(9), of the policyholder’s interest in the policy immediately before the death. The paragraph treats policies differently by date and type, and the account is reduced by capital dividends that became payable after the start of the period the definition sets. The exact arithmetic is in the definition, so have an accountant work it through for the policy in question.

Paying it to the shareholders

Under s.83(2) of the Income Tax Act, when a dividend becomes payable by a private corporation to shareholders of any class of its shares and the corporation elects, in prescribed manner and form and in respect of the full amount of the dividend, the dividend is deemed to be a capital dividend to the extent of its capital dividend account immediately before that time. Under s.83(2)(b), no part of the dividend is then included in the income of any shareholder. The election has to be made at or before the time the dividend becomes payable or, if earlier, the first day any part of it is paid; s.83(3) sets conditions under which a late election is deemed to have been made on time.

The anti-avoidance carve-out

Section 83(2.1) of the Income Tax Act applies notwithstanding s.83(2). If a share, or a share it was substituted for, was acquired by its holder in a transaction or series of transactions one of the main purposes of which was to receive the dividend, the dividend is deemed, for the purposes of the Act other than Part III and the capital dividend account, to be a taxable dividend and not a capital dividend, and s.83(2)(b) does not apply. Subsections 83(2.2) to (2.4) set out cases where s.83(2.1) does not apply. One of them, s.83(2.3), covers a dividend where it is reasonable to consider that its purpose was to distribute an amount included in the capital dividend account under paragraph (d) of the s.89(1) definition, the paragraph for life insurance proceeds. Anyone buying shares as part of a buy-sell should ask a tax adviser how that test reads on their facts.

Premiums and who owns the policy

Paragraph 20(1)(e.2) of the Income Tax Act allows a deduction for a life insurance policy (other than an annuity contract or LIA policy) of the least of three amounts: the premiums payable for the year, if an interest in the policy is assigned to a restricted financial institution in the course of a borrowing from it, the interest on the borrowing is or would be deductible as the paragraph describes, and the institution requires the assignment as collateral; the net cost of pure insurance determined under the regulations; and the portion that can reasonably be considered to relate to the amount owing under the borrowing. Separately, s.148(1) includes in a policyholder’s income, on a disposition of an interest in a policy, the amount by which the proceeds exceed the adjusted cost basis, other than for the plans and contracts the subsection excludes. The definition of disposition in s.148(9) does not include a payment in consequence of the death of the insured under a policy (other than an annuity contract) that is an exempt policy or was last acquired before December 2, 1982. So the type of policy and the policyholder’s identity matter. The existing answer on funding a buy-sell with insurance covers who can hold the policies.