The Canada Revenue Agency (CRA) is granted certain powers under the Income Tax Act (known as the “Act”) to satisfy an individual’s tax debts out of property that he or she transferred to a non-arm’s length person, such as a spouse, child or sibling. Where these rules apply, the recipient of the property is jointly and severally liable with the deceased for the tax debts (to a maximum of the fair market value of the transferred property).
The CRA has been successful in enforcing these rules in a number of court cases over the years. The most recent case, a 2020 Tax Court of Canada decision in Dreger v. The Queen, involved a life income fund (LIF) under which the deceased had named his two daughters as beneficiaries. The deceased had tax debts at the time of his death and the CRA sought to satisfy his obligations from the LIF proceeds paid to the daughters.
The daughters made the unique argument that they were no longer related to their father, and therefore not liable for his tax debts, because he was deceased. The Tax Court was not persuaded by these submissions and ruled in favour of the CRA. This decision is consistent with other court cases over the years in which this issue was considered.
Dreger and similar cases may prompt concern that the CRA has the power to seize life insurance proceeds payable to non-arm’s length beneficiaries of the deceased policy owner. Fortunately, there are many reasons why the rules considered in these court cases are inapplicable to life insurance proceeds:
- The Act contemplates the CRA’s collection powers arising out of a “transfer” of property to a non-arm’s length person. Life insurance proceeds are not transferred to a beneficiary in the same way that, for example, a RRIF or RRSP is transferred to a beneficiary. In the case of insurance proceeds, the payment is made from the insurance company rather than the deceased, and involves funds to which the deceased would not have been entitled while alive.
- The rules in the Act are designed to preserve the deceased’s estate so that tax debts can be satisfied. Insurance proceeds payable to a named beneficiary would not have been received by the estate in any case, therefore the CRA is not disadvantaged in that sense.
- There are previous Tax Court decisions that strongly indicate that life insurance proceeds are not subject to the same rules that applied in Dreger and similar cases.
There continues to be a strong argument that insurance proceeds paid to a non-arm’s length beneficiary cannot be accessed by the CRA to satisfy tax debts of the deceased. This is in contrast to registered plans and other assets that do not have the same degree of protection.
In this regard however, it is critical to distinguish between insurance proceeds paid to a named beneficiary versus those paid to the estate. Where the estate is the beneficiary of a policy, the proceeds will be exposed to all creditors of the deceased, including the CRA. For this reason, policy owners should designate specific beneficiaries whenever possible.