The Deemed Disposition at Death and Where the Death Benefit Sits

Death is a taxable event in Canada not because there is an estate tax, but because the Income Tax Act treats the person who died as having sold everything they owned a moment before dying. This page is about that fiction: what subsection 70(5) reaches, what escapes it, what the registered plan rules add, and where a life insurance death benefit sits relative to all of it. It does not cover how each amount arriving after a death is taxed in the hands of whoever receives it, which is set out separately, and it does not cover whether a creditor of the estate can reach the sum insured, which is also set out separately.

Everything below is general information written by a licensed insurance professional. Whether any of it applies to a particular estate is a tax question for a Chartered Professional Accountant, and in Quebec the administration of a succession is a notary's ground. Canadian Wealth Creation Centre Inc. is not authorized to give legal, tax or notarial advice and gives none here.

What is the deemed disposition at death?

It is a rule that treats a person as having sold every capital property they owned immediately before death, at fair market value, whether or not anything was actually sold. Paragraph 70(5)(a) of the Income Tax Act creates it. The gain or loss that results lands on the final return of the person who died, not on the heirs.

The statutory words are worth reading once, because the whole page hangs on them. Paragraph 70(5)(a) provides that the taxpayer shall be deemed to have, immediately before the taxpayer's death, disposed of each capital property of the taxpayer and received proceeds of disposition equal to its fair market value immediately before the death. Paragraph 70(5)(b) completes the circle: any person who as a consequence of the death acquires that property is deemed to have acquired it at a cost equal to that same fair market value.

Two consequences follow. The first is that the accrued gain on everything the person owned crystallizes on one day, at values nobody chose and at a moment nobody planned, and the tax on it belongs to the terminal return, which is the income tax return for the year of death. The second is that the heir starts fresh, at fair market value, so the same gain is not taxed twice. The estate pays once, the heir inherits a stepped-up cost, and the Act moves on.

What is often misunderstood is that Canada has no estate tax and no inheritance tax in the sense other countries use those words. Nothing is levied on the estate for being an estate, and nothing is levied on the heir for receiving. The tax is an income tax, on the deceased, computed as though the last day of life had been the busiest trading day of it. That framing decides everything that follows, including where a death benefit sits.

What property does the deemed disposition reach?

Capital property, which in ordinary households means the cottage, the rental property, a non-registered portfolio, the shares of a private company and any other asset carrying an accrued gain. It does not reach cash, which has no gain, and it does not by itself reach a registered plan, which the Act deals with under separate provisions.

The reach is by category rather than by value. Subsection 70(5) applies to each capital property, and a capital property is, broadly, property whose sale would produce a capital gain or a capital loss rather than business income. For most people that list is short and the accrued gain on it is concentrated in one or two items: a second property bought decades ago, or the shares of a company built over a working life. Those one or two items are where the terminal return is usually decided.

The family home is the exception most people know and the one most often overstated. Paragraph 40(2)(b) of the Income Tax Act reduces the gain on a disposition of a property that was the taxpayer's principal residence by a formula that counts the years of designation against the years of ownership. Where a home was the only property designated for every year it was owned, the reduction can be the whole gain. Where a family also owns a cottage, only one property can be designated for any given year, and the formula is applied to each. Which property to designate for which years is an accountant's exercise done on the terminal return, not a default.

Depreciable property carries its own wrinkle, because the deemed sale can recapture depreciation previously claimed on a rental building, and recapture is income rather than a capital gain. The shares of a private company are valued at fair market value on the day of death by somebody who then has to defend that number to the Canada Revenue Agency. None of this is exotic. These are simply the things that make the terminal return of an ordinary family larger than the family expected.

What does the rollover to a spouse or common law partner change?

It postpones the deemed disposition rather than cancelling it. Under subsection 70(6), capital property that passes to a spouse or common law partner resident in Canada, or to a qualifying spousal trust, is treated as disposed of at its cost rather than at fair market value, so no gain arises on the first death. The gain waits for the survivor.

The conditions are in the section. Subsection 70(6) applies where property of a taxpayer resident in Canada immediately before death, to which subsection 70(5) would otherwise apply, is transferred or distributed as a consequence of the death to the taxpayer's spouse or common law partner who was resident in Canada immediately before the death, or to a trust created by the taxpayer's will that meets the terms of the section, and where it can be shown, within the period ending 36 months after the death, that the property has become vested indefeasibly in the spouse, common law partner or trust.

The practical effect in a married household is that the first death is usually quiet for income tax on capital property. The second death is not. Everything that rolled over arrives at the survivor's death with the original cost still attached, plus whatever grew in the meantime, and it is disposed of under subsection 70(5) in one lump. Couples who have been told there is no tax at death have usually been told about the first death only.

The rollover can also be turned off, property by property, where the legal representative elects to have subsection 70(5) apply instead, which can be useful where the deceased has unused losses or an exemption to absorb the gain. That election, its timing and its interaction with the principal residence rules are precisely the kind of decision that belongs to a Chartered Professional Accountant preparing the terminal return, and this page does not attempt them.

What happens to an RRSP or a RRIF at death?

The whole balance is treated as income received immediately before death, at full rates, unless it passes to a spouse, common law partner or financially dependent child or grandchild under the provisions that allow it. Subsection 146(8.8) provides this for an RRSP and subsection 146.3(6) for a RRIF. There is no capital gain treatment; it is ordinary income.

Subsection 146(8.8) provides that where the annuitant under a registered retirement savings plan dies, the annuitant is deemed to have received, immediately before death, an amount as a benefit out of the plan equal to the fair market value of all the property of the plan at the time of death, less the amounts the subsection carves out. Subsection 146.3(6) provides that where the last annuitant under a registered retirement income fund dies, that annuitant is deemed to have received, immediately before death, an amount equal to the fair market value of the property of the fund at the time of the death.

The words that matter are deemed to have received. A person who never withdrew a dollar is taxed as though the entire plan had been withdrawn on the last day of life, and because a plan is fully taxable on withdrawal, the whole balance is income in that one year and pushed through the brackets in a single pass. For an estate whose largest asset is a registered plan, this line, not the capital gains line, is usually the largest item on the terminal return.

The relief is real but conditional. Subsection 146(8.9) permits a deduction from the deemed amount to the extent of a refund of premiums, which is broadly an amount paid on the death to a surviving spouse or common law partner, or to a financially dependent child or grandchild, and subsection 146.3(6.2) does the corresponding work for a designated benefit under a RRIF. What is not taxed on the terminal return is taxed in the survivor's hands unless it is transferred into a plan of the survivor's own. Again, deferral rather than cancellation.

Where does a life insurance death benefit sit relative to all this?

Outside it. A death benefit paid under an exempt life insurance policy on the death of the person insured is not a disposition of the policy, and the amount is not income to the person who receives it. The Act says so by exclusion, in the definition of disposition in subsection 148(9). Subsection 70(5) does not sell the contract.

Section 148 of the Income Tax Act governs the taxation of life insurance policies, and subsection 148(9) defines the word disposition for that purpose. The definition is inclusive, listing surrenders, policy loans and other events, and then states what disposition does not include. Paragraph (j) of that definition excludes a payment under a life insurance policy, other than an annuity contract, that is an exempt policy, in consequence of the death of any person whose life was insured under the policy. No disposition means no policy gain under subsection 148(1), and nothing to report on any return.

Two conditions sit inside that sentence. The policy must be an exempt policy, which is a test in the Income Tax Regulations that almost every individually owned life insurance contract in Canada is designed to meet and that the insurer tests each year. And the payment must be made in consequence of the death of the person insured, which is what distinguishes a death benefit from a surrender or a withdrawal during life, both of which are dispositions and both of which can produce a policy gain. The general rule and its edges are on the taxability page.

Read against the first half of this page, the position is simple. The deemed disposition sells the cottage, the rental, the portfolio and the company shares. The registered plan rules collapse the RRSP or the RRIF into income. Neither touches a death benefit, because the Act has been told in terms not to treat it as a disposition. The sum arrives at the named beneficiary by contract, on proof of death, as capital, and how it is treated once it has arrived, including where the estate itself is the beneficiary, is on the taxes at death page.

What does a death benefit not do about the tax at death?

It does not reduce it by a dollar. The tax under subsection 70(5) and under the registered plan rules is computed on the estate's other assets, and it is the same whether or not a contract exists. A death benefit changes only where the money to pay that tax comes from, and that liquidity is paid for in premiums.

This is the sentence most pages on this subject leave out. Nothing about owning a life insurance contract lowers the fair market value of a cottage, lowers the balance of a RRIF, or changes a rate in the Act. The terminal return is prepared as though the contract did not exist, because for the purposes of subsections 70(5), 146(8.8) and 146.3(6) it does not. An estate that expected a death benefit to make a tax bill smaller will find the bill unchanged and the benefit sitting beside it.

What the benefit does is arrive as cash, at the moment the estate needs cash, without a sale. The alternative sources of liquidity are the sale of the very asset that produced the gain, sometimes under time pressure at whatever the market offers that season, or borrowing against it. Whether liquidity from a contract is worth more than those alternatives depends on the size of the expected tax, the years of premiums it takes to fund the coverage, and the estate's other resources, and that arithmetic can go either way.

For a small estate it often goes the wrong way. Where the accrued gain is modest, the principal residence exemption covers the home, and the registered plan rolls to a survivor, the eventual tax may be smaller than the premiums paid over the years to insure against it. In that household the honest answer is that the estate can absorb the tax from its own assets, and a contract bought for that purpose would cost more than the problem it was bought to solve. Any illustration that does not put the total premium beside the expected tax is not an illustration of anything.

The comparison also runs on time. Premiums are paid now and every year; the tax is due at a date nobody knows. A person who lives a long time pays for a long time, and that is the plain arithmetic of the thing rather than a complaint about it. None of this is a reason to own or not to own a contract. It is the calculation a Chartered Professional Accountant and an insurance professional should be doing on the same sheet of paper before anything is signed.

What must the estate do before it distributes anything?

File the terminal return, pay the tax on it, and obtain a clearance certificate from the Minister under subsection 159(2) of the Income Tax Act before distributing property. In Quebec the liquidator of the succession does the same with Revenu Québec, so there are two returns, two administrations and two certificates. A representative who distributes early is personally liable.

The Act puts the obligation on the person, not on the estate. Subsection 159(2) requires every legal representative of a taxpayer, other than a trustee in bankruptcy, to obtain a certificate from the Minister, before distributing property in that capacity, certifying that all amounts for which the taxpayer is liable under the Act have been paid or security for payment accepted. Subsection 159(3) then provides that a legal representative who distributes without that certificate is personally liable for the amounts, to the extent of the value of the property distributed.

The order of operations follows from that. The deemed dispositions and the registered plan inclusions are computed, the terminal return is filed, the tax is paid or secured, the certificate is applied for and received, and only then does the estate pass what is left to the heirs. An executor pressed by a family to distribute early is being asked to take on the estate's tax debt personally, which is why the certificate is not a formality and why a careful representative refuses politely.

Quebec adds a second layer. The person administering the estate is the liquidator, named in the will or designated by the heirs, and the succession is settled under the Civil Code of Quebec rather than under provincial probate. There is a federal terminal return and a Quebec income tax return, and Revenu Québec issues its own certificate authorizing distribution, which the liquidator holds alongside the federal one before the heirs receive anything. The mechanics of that administration, its notices and its timing, belong to a notary; the figures on both returns belong to a Chartered Professional Accountant.

Who this suits, and who it does not

It suits a person who owns a second property, a private company or a non-registered portfolio and has never seen the accrued gain as a number. It suits a couple told there is no tax at death without being told which death. And it suits an executor or liquidator asked to distribute before the certificates arrive.

It does not suit a person whose estate is a designated principal residence, a registered plan rolling to a spouse and some cash, because the terminal return in that household is usually small and nothing here changes it. It does not suit anybody looking for a way to make the tax at death go away, because the Act does not offer one and a contract does not supply one. And it does not suit a person wanting their own estate's tax computed, which is an accountant's work on real figures.

The strategy is the Canadian application of the approach known as The Infinite Banking Concept®, originated by R. Nelson Nash; the mark belongs to Infinite Banking Concepts, LLC, with which this practice has no affiliation. Within the strategy a participating whole life insurance contract is held for what it does during life, and the position of its death benefit outside subsection 70(5) is a characteristic of the contract rather than a reason to own one. Where a household intends to hold the highest practical level of control over the capital-flow function in its own affairs, the state this practice calls Infinite Financial Sovereignty®, the liquidity at death is a consequence of the design and not its purpose.

Everything here is written by a person paid by commission from an insurer when a contract is issued, which is stated at the foot of every page. Insurance is insurance, it is not an investment, and the dividends on a participating contract are not guaranteed. The tax on an estate is computed by a Chartered Professional Accountant, the succession is administered in Quebec by a notary, and both are consulted before anything on this page is acted on. What a beneficiary designation means for a de facto couple in Quebec is on the family patrimony page.