2020-0842171C6 CALU 2020 – Q4 - Segregated Funds and 85(1)

Principal Issues: Can an interest in a related segregated fund trust be transferred to a corporation under section 85?

Position: An interest in a segregated fund trust can generally be transferred to a corporation under section 85.

Reasons: An interest in a related segregated fund trust is generally considered capital property and as such, eligible property as defined in subsection 85(1.1) for purposes of subsection 85(1).

Author: Naufal, Bob
Section: 138.1; 39; 85

2020 CALU CRA Roundtable – July 2020

Question 4 - Segregated Fund Policies and Section 85 Rollover

Background

Subsection 85(1) of the Act allows for a tax-deferred transfer of “eligible property” to a corporation where the consideration includes shares of that corporation. Eligible property, for the purposes of this provision, is defined in subsection 85(1.1) of the Act to include “(a) a capital property (other than real or immovable property, an option in respect of such property, or an interest in real property or a real right in an immovable, owned by a non-resident person)”.

Section 54 of the Act defines capital property to include “(b) any property (other than depreciable property), any gain or loss from the disposition of which would, if the property were disposed of, be a capital gain or a capital loss, as the case may be, of the taxpayer”.

In turn, pursuant to subparagraph 39(1)(a)(iii) of the Act, a taxpayer’s capital gain excludes the taxpayer’s gain from the disposition of an insurance policy, including a life insurance policy, except for “that part of a life insurance policy in respect of which a policyholder is deemed by paragraph 138.1(1)(e) to have an interest in a related segregated fund trust”.

Finally, paragraph 138.1(1)(e) of the Act reads in part as follows:
(e)   where at any particular time there is property in the segregated fund that was funded with a portion of the premiums paid before that time under a segregated fund policy,

(i) the respective segregated fund policyholder is deemed to have an interest in the related segregated fund trust that is not in respect of any particular property or source of income …

Based on the provisions set out above, since the disposition of a taxpayer’s deemed interest in a related segregated fund trust should result in a capital gain (as a result of not being excluded from the meaning of capital gain in paragraph 39(1)(a)), the deemed interest should also be a capital property as defined in section 54 of the Act.

Described Scenario

Ms. A invests $100,000 into a segregated fund policy (the “policy”) under which she is the annuitant and her spouse is designated as beneficiary under the policy. The policy contains guarantees which provide that upon its maturity in 15 years the amount payable under the policy to Ms. A will be the greater of 75% of the original deposit (i.e., $100,000 x 75% = $75,000) and her share of the fair market value of the investments in the segregated fund. In the event that Ms. A dies prior to the maturity of the policy, an amount equal to the greater of the original deposit ($100,000) and her share of the current fair market of investments in the segregated fund will be paid to her spouse as beneficiary.

Assume that in year 7, the fair market value of Ms. A’s interest in the segregated fund policy (based on the fair market value of the investments in the segregated fund) has increased to $140,000. At that time, Ms. A’s adjusted cost base of that interest is $120,000. Ms. A wants to transfer the interest in the segregated fund policy into a taxable Canadian corporation (Opco) under subsection 85(1) of the Act and will only receive common shares in Opco as consideration. Ms. A and Opco will jointly elect in prescribed form within the period specified under subsection 85(6) of the Act. The elected amount agreed upon by Ms. A and Opco will be $120,000 and the beneficiary under the policy will be changed to Opco.

Question

Can the CRA confirm that Ms. A’s interest in the segregated fund policy may be considered an eligible property under paragraph 85(1.1)(a) of the Act for purposes of subsection 85(1) of the Act.

CRA Response

Subsection 138(12) of the Act defines a "life insurance policy" to include an annuity contract and a contract issued by an insurer where all or any part of the insurer's reserves for such a contract vary in amount depending on the fair market value of a specified group of assets (defined in subsection 138.1(1) of the Act as a "segregated fund").

Under the current scheme of the Act, two distinct types of interests are contemplated for life insurance contracts that are segregated fund policies. First, there is the interest in a contract that is deemed under subparagraph 138.1(1)(e)(i) of the Act to be an interest in a related segregated fund trust (“the first interest”). Second, there is the remaining interest in the life insurance policy that is not deemed to be an interest in a related segregated fund trust (“the second interest”). The adjusted cost base of the first interest is determined by section 53 of the Act, while subsection 148(3) of the Act excludes amounts relevant to the first interest from the adjusted cost basis of the second interest.

In a scenario such as the one described above, a disposition of an interest in a related segregated fund trust will generally result in capital gains treatment under subparagraph 39(1)(a)(iii) of the Act. In such a case, the interest may be considered a capital property, and accordingly, an eligible property under paragraph 85(1.1)(a) of the Act for purposes of subsection 85(1) of the Act. 

Bob Naufal
July 8, 2020
2020-084217

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