Business Continuation Planning

Ownership of a business interest creates the need for several additional areas of financial planning in addition to the personal financial security planning for the owner. These may include succession planning, tax planning and business continuation planning.

Business continuation planning is the process of identifying risks that may imperil the profitability or even the viability of the business and implementing appropriate risk management strategies to minimize, eliminate or transfer these risks. These strategies are critical, not only to survival of the business, but to ensure that the business can be relied upon to provide for the owner, as expected, at retirement, death or in the event of disability or critical illness.

Key Person Protection

A frequently overlooked risk to businesses is the loss of key personnel to death, disability, critical illness or unexpected departure from the business. The unanticipated loss of a key person, particularly in the case of a sole owner who is the driving force behind business operations, may create numerous problems that threaten the viability of the business.

Business performance may lag due to the absence of the individual. Costs will be incurred to replace the individual. Suppliers may tighten payment terms. Customers will think twice about using the business as a supplier of product or service. Other employees may be enticed to other career opportunities during the confusion and uncertainty.

The focus of this paper, however is the impact of the restriction, withdrawal or increased cost of credit that may be caused by the loss of a key person.

What are Business Credit Losses?

There are several potential sources of loss, or more accurately, cash flow crunch, when a key person is lost to death or disability. These include the following:

• Business loans that may be called or for which there is a desire to retire
• Lines of credit that may be reduced or retracted
• The impact of some suppliers moving to C.O.D. for a period of time
• Increased cost of debt service if carrying charges are increased

This has the potential to be catastrophic, particularly in a period of time when cash flow may be otherwise reduced or constrained by the departure of the key person.

Business Credit Risk Management

Business credit protection is really a sub-set of key person protection planning. Business credit risk is just one of the financial and operational risks that must be managed on the death or disability of a key person. (See 'Key Person Protection')

Any of the following risk management strategies may be available to deal with particular business credit risks:

• Avoidance
• Retention
• Transfer
• Risk avoidance is generally not a viable option since it's impossible to categorically ensure key people will not die or become disabled.
• Risk retention involves accepting the possibility of a loss on the basis that it will be financed out of business cash flow or credit. Again, risk retention is not always viable in the case of business credit risk. The impact of contracting or more expensive credit to the business may be so substantial as to be catastrophic. It may not be possible to internally finance the cash flow and profit impact of the credit contraction that occurs on the death or disability of a key person.
• The third common strategy involves transferring the risk an insurer. For the cost of annual insurance premiums, the insurer will provide capital to deal with the credit contraction in the event of the death or disability of a key person.

Quantifying the Potential Loss

The total of the amounts listed above roughly represents the cash flow and business value impact of the business credit retraction or interest rate increases.

Following is an example of a relatively thorough estimate of the business credit 'loss' in the event of death. Where debt is contracted, this is not a 'loss' from an accounting standpoint. However, it does represent a cash flow crisis that can threaten the viability of the business unless replacement capital can be obtained.

Key Person Life Insurance for Business Credit Protection

In the event of the premature death of a key person, life insurance provides an instantaneous injection of capital into the business. This cash can not only repay debt that is demanded and credit that is contracted, but can also reassure creditors, suppliers, customers and employees that the business will 'weather the storm'.

Creditor provided insurance
In some cases, the lender will offer insurance provided to it by a life insurance company (similar to group or association insurance). The cost of this insurance will be paid by cash fee or by adding the fee to the loan balance.

'Individual' Insurance
Renewable term insurance is the starting point. Generally, term insurance can be purchased very economically. As to whether insurance of a more permanent or costly nature should be purchased, this depends upon a number of other factors:

• Where the need for protection may extend over a longer time frame, it may be prudent or more cost effective to select a product such as universal life with minimal deposits or participating insurance with term enhancement dividend option.
• Where there is a need or desire to create a funded supplemental compensation structure for the life insured individual, universal life with significant deposits or participating insurance with the paid-up additions dividend option could be considered.
• The starting place is term insurance for the immediate need. However, these other considerations along with affordability may dictate the selection of other products. The policy assigned can be a new policy or existing policy.

Taxation¹ and Creditor Protection of the Life Insurance Policy

Generally, the business is the owner, premium payer and beneficiary of key person life insurance purchased for key person purposes. The general rule that apply to policies such as these are as follows:

• Premiums are generally not deductible. If the insurance is required by a lender as collateral for the debt and certain other Income Tax requirements are met, a portion of the premium may be tax deductible for the company.
• The death proceeds will be received tax-free by the company.
• For certain Canadian private corporations, the difference between the death proceeds and the adjusted cost basis of the policy can be added to the "capital dividend account" of the company. Through a tax election, the capital dividend account can be utilized to cause future dividends to be paid tax-free to shareholders up to the amount of the capital dividend account.
• The cash surrender value of the policy, if any, and the death proceeds, when received, will be exposed to creditors of the business.

Premium deductibility

What kinds of policies qualify for deductibility?
For premiums paid after 1989, the premiums on any type life insurance policy (term, U.L., whole life etc.) qualify for deductibility. Prior to that, only term insurance premiums qualified.

Standard credit insurance, offered as part of a loan offering by a lending will not generally qualify for deductibility as an insurance cost or as a general cost of borrowing². In this case, the lending institution is the owner of the insurance contract.

When can premium be deducted?
A portion of insurance premiums on life insurance used as collateral against business debt may be deductible under certain specific circumstances3:

• An interest in the policy must be assigned to a 'restricted financial institution^4' in the course of borrowing from the institution.
• This assignment must be required by the restricted financial institution as collateral for the borrowing⁵.
• The interest payable in respect of this borrowing must be deductible in computing the business' income for the year.

A restricted financial institution generally refers to a bank, insurance company, trust company, credit union or a business whose principal business is the lending of money to persons with whom it deals at arms length.

What is a premium?
The word 'premium' implies and out-of-pocket payment. Where the policy owner is no longer paying premiums out-of-pocket, is there any entitlement to a deduction? According to the C.C.R.A. (Revenue Canada), the answer is 'no^'6. Both universal life and participating whole life policies offer the possibility for the policy owner to stop making any out of pocket payments. This can occur when the accumulated cash within the policy is sufficient to finance the contractual premiums, in the case of participating whole life, or the insurance and other charges, in the case of universal life. According to the C.C.R.A., when contractual premiums or insurance charges are internally funded out of policy values, this does not constitute 'premiums payable^'7.
For this reason, caution should be taken when planning to front end load deposits to a universal life policy that will be collaterally assigned and otherwise meets the requirements for deductibility. The likely loss of any deductibility once deposits are discontinued should be taken into account in making this decision.

How much can be deducted?
If the conditions above are met, how much of the premium can be deducted? It is rare that the entire premium is deductible. Calculation of the amount deductible is a two step process.

• Step 1: Take the lesser of the premiums paid by the taxpayer (who must also be the policy holder8) in the year and the net cost of pure insurance⁹ for that year¹⁰. The net cost of pure insurance (NCPI) is often available as a custom column option in the illustrations provided by the insurer.
• Step 2: Take the amount from Step 1 and prorate (reduce) it to the amount that 'can reasonably be considered to relate to the amount owing from time to time during the year by the taxpayer to the institution under the borrowing^11'.

What does 'reasonably relate' and 'from time to time' mean?
According to the C.C.R.A., factors that would be considered include:

• The extent to which there was other collateral available against the loan¹² when there is a question as to whether the lender truly demanded that life insurance be assigned, and/or
• The extent to which the insurance death benefit, on average, was greater than the loan balance over the course of the year. For example, if the life insurance coverage on the assigned policy was $500,000 and the average loan balance over the year was $200,000, the amount of insurance premium deductible would be 40% ($200,000/$500,000) of the lesser of the premium and NCPI for that year. It is necessary to review the balance of the loan over the year and determine the average balance before doing this calculation.

If there is other collateral assigned, but it is clear the insurance assignment is legitimately required by the lender, the deduction otherwise available for the life insurance premium will not necessarily reduced. For example, assume the collateral assigned against an outstanding loan of $500,000 is both an insurance death benefit of $500,000 and $500,000 of inventories. The deduction for insurance premiums would not necessarily be denied or reduced because the inventory already provided sufficient collateral. However, existence of this other collateral could bring into question whether the insurance policy really 'is required by the institution as collateral for the borrowing^'13.

Policies on more than one life assigned
If policies on the life of more than one employee have been assigned, each policy will be considered separately. That is, provided each policy is legitimately required, it is treated as if it were the only life insurance policy assigned as collateral for the loan.

A more thorough example from C.C.R.A. IT-309R2.

• A corporation with a December 31 year-end borrows $400,000 from its bank on January 1.
• The bank (a restricted financial institution) requires the following collateral:
  • Assignment of existing life insurance policies on two senior officers of the corporation A pledge of fixed assets (with a fair market value of $100,000)
• On June 30, the corporation repays $100,000 of principal on the loan (reducing the loan balance from $400,000 to $300,000).
• The insurance policies have the following attributes:

As you can see, the lesser of the insurance deposits made and the NCPI in the taxation year was prorated to reflect the fact that the insurance death benefit was greater than the loan outstanding during parts of the year. Where the policy year overlaps (i.e. is not the same as) the taxation year of the business, it will be necessary to take premiums paid and NCPI from the parts of the two policy years that fall in the taxation year of the business.

Another important point to note is that the tax deduction available is not substantial enough that obtaining tax deductibility would be either a reason to purchase insurance or to unnecessarily assign a policy to a lender. For example, in this case, assuming a 22% small business tax rate, the tax savings would be, respectively:

$115 on Policy I which has an annual premium of $1,000
• $123 on Policy II which as an annual premium of $800

The tax savings represents only about 10-15% of the premiums paid and a fraction of a per cent of the death benefit being purchased.

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Interest on borrowings to purchase the life insurance

Generally speaking, interest on borrowings used to purchase life insurance is not deductible¹⁴.

Some strategies in the marketplace call for a corporation to purchase an annuity certain or life annuity, the payments from which are used to make the insurance deposits/premiums. Interest on borrowings to buy a non-registered annuity is deductible in a given taxation year only up to the amount of taxable annuity income declared on that annuity in the year¹⁵. Compound interest will only be deductible when actually paid16. Note also that the interest portion of prescribed annuity payments would not be deductible¹⁷.
Furthermore, where it is evident the annuity is in fact being used to purchase life insurance, the Canada Customs and Revenue Agency (C.C.R.A., formerly Revenue Canada) has indicated it is conceivable it would seek to disallow the interest expense under the general anti-avoidance rule¹⁸. Their basis for this would be the premise that the loan was effectively financing the purchase of life insurance rather than an annuity or segregated fund¹⁹.

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The capital dividend account

The purpose of key person insurance (including insurance intended to pay down business debt) is primarily for business purposes. However, the Income Tax Act creates the opportunity to use some of these insurance proceeds (or funds from other sources for that matter) to pay tax-free dividends to shareholders.

When a death benefit is paid to the corporation, there is an increase to the Capital Dividend Account (CDA) equal to the difference between the proceeds received on death and the adjusted cost basis (ACB) of the policy to that corporation20. The company can pay dividends or create deemed dividends and elect that these dividends be tax-free to the recipient to the extent of the capital dividend account existing at that time21.

The money used to finance these dividends does not have to be the insurance death benefit. In fact, the insurance proceeds can be spent on key person needs and, at some future date, when other cash becomes available, a capital dividend can be paid.
Again, standard creditor insurance that is owned by the lender (but may be paid for directly or indirectly by the borrower) does not increase the CDA at death because the insurance proceeds are not considered to have flowed first the borrower and then to the creditor. They are considered to have been paid directly to the lender.

Example

A corporation takes out a life insurance policy of $500,000 that is collaterally assigned to a lender against a $500,000 debt. The life insured employee dies, and in accordance with the loan agreement, the insurance proceeds are used to pay off the loan. The adjusted cost basis (ACB) of the insurance policy is $10,000.

Cash flow
Death proceeds	$500,000
Paid to bank	500,000
Net cash to company	$ 0
Capital Dividend Account
Death proceeds	$500,000
ACB of policy	10,000
Increase to capital dividend account	$490,000

As you can see, even though the insurance proceeds went to the bank, there is still an increase to the capital dividend account equal to the death proceeds (less the ACB). At any future time, when the company can come up with cash or assets from some other source, they can pay a tax-free capital dividend of $490,000. It's important to remember that under an absolute assignment (i.e. a transfer of ownership), there will be no capital dividend account increase on death for the corporation.

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Reduction of Losses from Forgiven Debt

Where business debt is forgiven, the Section 80 of the Income Tax Act essentially deems the amount forgiven to be income and provides rules for how this forgiven debt should be applied²².

Where the debtor pays the premiums for the insurance that is used to pay off the debt, directly or indirectly, the proceeds are not considered to have been used to pay off the debt for the purposes of Section 80. Therefore, the debt extinguished by the death proceeds is instead considered to have been forgiven, creating income that is applied according to the rules under Section 80. This is a negative consequence of insurance that is not considered to have been paid for by the debtor business.
provided the debtor business pays for the cost of the insurance, directly or indirectly, the insurance proceeds will be considered to have been used to pay down the debt and Section 80 will not apply.

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The Capital Gains Exemption

Canadian residents are entitled to a lifetime exemption from $500,000 of capital gains on the sale or deemed disposition of shares of a 'qualified small business corporation^'23. To meet the definition of qualified small business corporation, there are a number of tests related to the percentage of business assets that are 'used principally in an active business'.

The question arises as to whether a corporate owned life insurance policy, assigned as collateral for a business loan, would be considered an asset used principally in an active business or rather a passive 'investment' type of investment. According to the C.C.R.A., the policy represents an investment²⁴. Therefore, according to the C.C.R.A., it can not be included as an active business asset.

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Key Person Disability Insurance

• Disability insurance can be utilized in a number of ways and there are several types of disability policies designed to meet particular key person protection needs including:
• Salary continuation plans
• Business overhead expense
• Typically, it is not assigned as collateral for debt.

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Key Person Critical Illness Insurance

• Critical illness insurance provides protection with respect to a key person who is afflicted by specified diseases or health problems that do not necessarily render them disabled but nevertheless affect their productivity or their desire to work to the same extent as before.
• This coverage will pay a lump sum or, in some cases, a stream of income, to the business that will both help to recover losses created by the absence or lower productivity of the individual. This will allow for more flexibility in offering time or resources to allow the individual to recover from or deal with the affliction and potentially to pay for temporary or permanent assistance in carrying out the key person's role.

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Summing it Up

A thorough review of financial security objectives for a business owner should always include an analysis of the potential reduction in business value created by business credit contraction and the risk management strategies that can be implemented to deal with them.

However, it's important not to let what may be a relatively insignificant tax savings motivate a client to ask a lender to accept insurance as security when it has not been requested. This arrangement will probably not withstand the test of the assignment being 'required' by the lending institution for tax deductibility purposes. In addition, it may be that the policy was required for other key person loss protection. If the death proceeds are used to pay off the loan on death, it will reduce the capital that otherwise would have been available to defray other business losses created by the death.

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Endnotes:

• All references to taxation in this paper assume a corporate business.
• C.C.R.A. Views 9407245, standard lender provided insurance is not deductible under 20(1)(e) as 'expenses re financing' or under 20(1)(e.1) as 'annual fees, etc. (re borrowings)'
• Income Tax Act, 20(1)(e.2)(i)
• Income Tax Act, 248(1), definition of 'restricted financial institution'
• C.C.R.A. IT-309R2. An unused line of credit does not qualify the business for any deduction as it is not considered an 'amount owing', even if a 'standby charge' is payable to maintain the availability of the unused line
• C.C.R.A. Technical Interpretation 9901875
• 'Premiums payable' is the term used in paragraph 20(1)(e.2)
• C.C.R.A. Views 9528015
• Represents the pure cost of insurance for that year. Does not necessarily correspond to the 'COI' charges in a universal life policy. The NCPI is available on the new sales and in-force illustrations of many insurers
• Where the corporation's taxation year does not correspond with the insurance policy year, the premiums or NCPI for the two applicable policy years should be prorated to match the taxation year.
• ITA 20(1)(e.2)
• C.C.R.A. IT-309R2 and Views 9204595. Where there is a genuine requirement for a specific amount of collaterally assigned life insurance by the restricted financial, the presence of other collateral security will not necessarily require a proration of the amount of insurance premium/NCPI that is deductible
  under 20(1)(e.2)
• ITA 20(1)(e.2)(i)(C) and C.C.R.A. Views 9414527
• ITA 20(1)(c)(i) and (ii), IT-355R2
• ITA 20(1)(c)(iv)
• ITA 20(1)(c)(iv) and 20(1)(d)
• ITA 20(1)(c)(iv)
• ITA 245
• C.C.R.A. Views 9606425
• ITA 89(1), definition of 'capital dividend account', SS d(i)
• ITA 82(2), definition of 'capital dividend'
• ITA 80(3)-(14) prescribes the order in which the forgiven debt must be applied. First against non-capital losses of other years, then capital losses of other years etc.
• ITA 110.6(1)
• C.C.R.A. Technical Interpretation 9906865