Appeal Court deems universal life insurance policy is not income from property

The ruling, the first time a Canadian court dealt directly with the taxation of inducements received from a broker to purchase a life insurance policy, examines the reach of section 87(w) of the Quebec Taxation Act and its equivalent section 12(1)(x) of the federal Income Tax Act, clarifies the concept of “income from property” as opposed to a taxable “benefit,” and serves as a warning to taxpayers to examine the tax consequences of schemes, according to tax experts.

“This judgment is very interesting from a tax law perspective because it provides an interpretation of the concept of ‘income’ in a context where federal and provincial legislation is silent on the matter,” said Montreal lawyer Meriem Amir of Astell & Associés, who successfully pled the case. “The Court also explains the scope of section 87(w) of the Taxation Act, which until then had never been interpreted by a Court of Appeal.”

The “message” stemming from the ruling is that incentive programs are not sheltered from the prying eyes of tax authorities, said Christopher Mostovac, a founding partner of the Montreal tax litigation boutique Starnino Mostovac LLP. “There’s no question that the ultimate impact of the decision is that whenever you’re involved with an incentive program, at one point, what you receive back as an incentive, they’ll find a way to make it taxable,” said Mostovac.

Montreal tax litigator Paul Ryan asserted that both the provincial and federal income tax provisions dealing with incentive payments “needs to be looked at very carefully” by tax specialists as it appears they are “taking an increasingly wide scope” following this Appeal Court decision and a recent ruling by the Federal Court of Appeal in Glencore Canada Corporation v. Canada, 2024 FCA 3 – a judgment cited with approval by the Quebec Court of Appeal.

The ruling has yet another significant implication, aimed at taxpayers, added Ryan. There is a risk that the time limit for prescription will not apply if taxpayers fail to do their due diligence before embarking on shady schemes, warned Ryan. “It looks bad from the outset, and there’s a stronger presumption against you,” noted Ryan.

The case deals with an illegal financial scheme devised by Guillaume Chabot, an insurance broker. He persuaded André Verrier, the appellant, to participate in a scheme allowing him to take out a universal life insurance policy, which combine permanent life insurance with an investment component. These financial products offer significant tax advantages as income generated in the investment account is not taxed annually since it is an exempt policy with the meaning of tax legislation, points out the Appeal Court. In general, the higher the death benefit provided by the policy, the more funds can be accumulated and income generated in the investment component without annual taxation. But the amount of life insurance and the amount that can be paid into the investment account are subject to regulatory restrictions. The costs of these insurance contracts are high and the commissions paid to brokers are considerable, added the Appeal Court.

Chabot, who has since been permanently struck off the roll of the Chambre de la sécurité financière, concocted a scheme that would line his pockets through the generous commissions paid to him by insurance companies when one of his clients subscribed to a universal life insurance policy. The minimum payments required to keep the contract in force for the first few years were less than the commissions paid to Chabot during those years. Chabot or one of his companies would as a result reimburse clients the full amount paid to the insurers for the time required for the commissions to vest. Once this period had elapsed, the client could then choose to stop making payments to the insurer, thereby forfeiting the contract, or continue making payments in order to keep the contract in force. Most of Chabot’s clients, including the appellant, chose to stop making payments to the insurers as soon as they were no longer being reimbursed by Chabot or its companies. All told, Chabot improperly underwrote 39 insurance policies, and received more than $5 million in illegitimate commissions and bonuses, nearly half of which ($2.1 million) he used for advances paid to his clients to pay insurance premiums to the insurer and for surpluses to maintain the policy until the commissions and bonuses could be recovered.

Verrier, the appellant, was informed of the illegal nature of the scheme, but decided nevertheless to forge ahead as it would allow him to benefit from the contract at no cost to him. Under the contract, which came into effect on January 2008, Verrier was required to pay the insurer a minimum monthly amount of $24,862.31,6 but in fact paid approximately $25,000 monthly. Most of the monies paid by Verrier under the contract were credited by the insurer to the investment account, since the costs of maintaining the appellant’s life insurance were substantially lower in the early years of its operation.

In 2009, things turned sour. Market regulators got wind of the scheme, and Chabot stopped paying the incentives to the appellant, who likewise stopped making payments to the insurer under the agreement. The insurer, applying the forfeiture test, terminated the appellant’s contract without remitting the amounts credited to his investment account. On top of that, Revenue Quebec became involved, and reassessed many of Chabot’s clients. The Quebec tax man in 2015 added an amount of nearly $300,000 to Verrier’s income for 2008 and 2009 because it deemed that the amounts he received from Chabot or his companies to reimburse him for the payments made under the agreement constituted inducement payments taxable under s. 87(w) of the Taxation Act.

Verrier, along with 22 other clients, appealed Revenue Quebec’s assessments before the Court of Quebec. Under s. 87(w) of the Taxation Act, a taxpayer must include in computing income from property for a taxation year any inducement payments received from a third party in the course of carrying on the taxpayer’s own business for the purpose of deriving a benefit therefrom. In Verrier c. Agence du revenu du Québec, 2023 QCCQ 52, Court of Quebec judge Chantal Gosselin concluded that the conditions set out in s. 87(w) of the Taxation Act were met, and dismissed the appeals.

Verrier appealed, arguing that the trial judge erred in concluding that the contract entered into with the insurer was income from property. He maintained that he did not actually earn income from the contract because he never collected the investment income credited to his account, given that during the entire period the contract was in force its cash surrender value was nil. As a result, added Verrier, there was no income property within the meaning of s. 87(w) of the Taxation Act. Verrier also argued that this provision does not apply to life insurance policies.

NO CASE LAW

“This is not a case that lends itself to a summary response,” said Quebec Appeal Court Justice Robert Mainville in Verrier c. Agence du revenu du Québec, 2024 QCCA 298, in a unanimous decision, with Justices Stéphane Sansfaçon and Michel Beaupré concurring. “The issue is complex, and there is no case law from this Court or from any other Canadian province that deals directly with the imposition of inducements received from a broker to purchase a life insurance policy.”

Mostovac couldn’t agree more. “Tax law is one thing,” said Mostovac. “When you mix insurance law and tax, it’s a new animal. It’s a whole different ballgame. Because insurance, just the language of policies evolves to avoid some of these pitfalls. It’s always changing.”

The Appeal Court held that s. 87 (w) of the Taxation Act, introduced in 1987, has the same objective as the equivalent of of its federal counterpart, s. 12(1)(x) of the Income Tax Act (ITA), enacted in 1986. Even though the tax system established by the Quebec Taxation Act is distinct and autonomous from the federal tax regime, “there is no doubt” that the two systems act in harmony with each other in most of their provisions, particularly when it comes to the fundamental principles governing the calculation of income, held the Appeal Court. That also applies to s. 87 (w) of the Taxation Act and its federal equivalent. Both must interpreted in the same way, added the Appeal Court.

“This section was added to close the loopholes in the law where there were non-taxable amounts, by saying that incentive payments would be taxable,” said Ryan. “This section is very broadly worded.”

INCOME & BENEFIT NOT THE SAME THING

The Appeal Court partially overturned the lower court decision, holding that the trial judge confused the concept of “income” with that of a “benefit.” Both the provincial and federal income tax laws do not define what constitutes “income,” said the Appeal Court. But the the determination of what constitutes income in a given case is based on a number of factors, including the existence of an express provision in the Taxation Act, case law in similar cases, accounting principles and commercial realities, said the Appeal Court. Both tax laws treat life insurance coverage in certain cases as a taxable benefit for the insured, but not as a source of income from property. The Appeal Court, heeding guidance from Vern Krishna, tax counsel with KPK Law LLP and a law professor at the University of Ottawa who wrote The Fundamentals of Canadian Income Tax, concluded that the insurance coverage provided for in the contract does not constitute income from property, although it is “indeed” a benefit. “However, in the absence of a legislative provision providing for the inclusion of this benefit in the appellant’s income, it cannot constitute a taxable benefit, just as the premiums paid to provide the insurance coverage cannot be deducted from the appellant’s income,” held the Appeal Court. “Nor could this benefit constitute income from the use of property within the meaning of paragraph 87w) Taxation Act.”

The Appeal Court’s “restrictive” interpretation of the taxable benefit in the absence of a legislation provision providing for the inclusion of that benefit in a taxpayer’s income is auspicious, said Bruno Racine, jointly in charge of the tax division at Langlois Lawyers. “This interpretation of the law, which limits the scope of taxation of “benefits” to those provided for in the law, is to be welcomed,” added Racine, a member of the law firm’s Board of Directors.

Mostovac is far from certain. “Although the Court is clear not to mix up income and benefit, but the way it dealt with that, I’m not sure we’re any further ahead of the game to determine what income is,” said Mostovac.

The universal life insurance policy also had an investment component to it, with almost two-thirds of the payments made by the appellant under the contract were deposited by the insurer in the investment account in his name. The Appeal Court “rightly concluded” that this part of the contract objectively constituted property used for the purpose of gaining or producing income, said Racine.

The Court of Appeal also “rightly concluded,” added Racine, that “the portion of the inducements received in respect of the payments made by the appellant to the insurers for the purpose of the investment account provided for in the Contract (that is, approximately two-thirds in the appellant’s case) are caught by s. 87(w) of the Taxation Act.” The portion of the inducements received with respect to the payments made by the appellant to the insurers for the purpose of the life insurance coverage alone, estimated to be one-third, is not captured by that section.

“The most important thing the Appeal Court said in this ruling was that insurance is not income,” said Ryan. “They’re right to say that. Insurance is not income. When you die, you receive insurance. It’s not income. So it’s not covered by this section. I think they’re right in that part of their analysis.”

It will be interesting to see whether the case is appealed to the Supreme Court of Canada, as the issues raised are of national interest, said Racine. “If not, it will be interesting to see how the courts apply this decision, both in terms of imposing incentives and interpreting tax law, particularly the concepts of ‘income from property’ versus ‘taxable benefit’,” said Racine.