10/8 insurance arrangements offer Canadian investors unfair tax advantages.
So says Budget 2013, which aims to level the field at tax time by cutting the benefits these policyholders are offered.
Under 10/8 arrangements, clients invested in life insurance policies with the intention of borrowing against them at a 10% interest cost. They were then guaranteed credits to their policies of approximately 8%.
The CRA considered 10/8 loans as investment-related prior to the budget, so the after-tax costs of borrowing fell to 5.5% or less. Tax deductions were determined annually, with people saving 45% of 10%, or 4.5%. This resulted in a net cost of 5.5%.
This strategy was traditionally marketed to closely held private corporations and wealthy customers.
That’s because buyers had to make substantial deposits for the 10/8 loans to be taken out in the first place, says Byren Innes, senior vice president and director of New Link Group. He adds people generally bought their policies for upwards of $5,000,000, with premiums running at $100,000 for several years.
It was a profitable strategy, adds Innes, and therefore drew the attention of the government and CRA. The budget states, “In the absence of the tax benefits, the investing and borrowing would not [have been] undertaken.”
So, CRA proposed to deny the following benefits as of March 21:
- the deductibility of interest paid or payable on the borrowing that relates to a period after 2013;
- the deductibility of a premium that is paid or payable under the policy that relates to a period after 2013; and
- the increase in the capital dividend account by the amount of the death benefit that becomes payable after 2013 under the policy and that is associated with the borrowing.
Read: Budget 2013 looks a lot like 2012, for insurers’ initial reactions to the budget
What’s more, CRA didn’t grandfather 10/8 arrangements entered into prior to Budget Day. Instead, all of these policyholders are being encouraged to wrap up their loans by repaying them before January 1, 2014 without income tax consequences.
A surprise to the industry
In CALU’s post-budget report, it said, “CRA has been “unhappy” with certain leveraged insurance arrangements for a while. In particular, leveraged insured annuities and 10/8 programs.”
However, it adds the agency has “struggled to get traction in both identifying and creating assessing positions that it felt would be supported in Court if challenged by taxpayers.”
This is why industry players and advisors alike were surprised when the budget’s proposals came down the pipe. The report says CRA’s proposed measures are “very targeted [and] designed to eliminate most, if not all, of the benefits of such arrangements. We will be consulting closely…on these proposals to determine our response to Finance.”
Further, CALU president Kevin Wark says, “Industry players had made efforts to educate both the CRA and Finance on the nature of the [10/8] loan program” and its benefits over the last few years.
Overall, he says the market for 10/8 programs is much broader than that of leveraged insured annuities—which were grandfathered if entered into before Budget Day.
LIAs combine an annuity, a life insurance policy and a loan within a private corporation. Rather than using company capital, business owners use the loan to purchase their insurance and then write off the interest. They’re typically held by shareholder age 60 and over.
In contrast, 10/8s are held by customers of all ages, as well as by these older business owners.
Wark adds, “In the vast majority of 10/8 cases, the insurance was purchased for an estate-planning or business succession need.” The leveraging program was only an option, but Innes says it was likely difficult to pass up due to the tax savings available.
Options for policyholders
For clients to wind up their 10/8 loans, they would need sufficient capital.
This is important because the loans don’t have payback schedules, says Innes.
Read: Beware leveraged loans
He adds, “The loans are [often] set up to never be paid in cash, but rather be paid off from the proceeds at death. In this way, the loan balances would be deducted from the tax-free proceeds of a death benefit.”
Further, “As long as the asset purchased with the loan qualified as an investment opportunity, the interest would have continued to be deductible. So paying off the loan would not be desirable.”
Insurers also needed to collect the 10% interest payments to be able to credit the 8% to the policies.
Continue on to find out how clients can deal with their loans, as well as how to discuss 10/8 policies with them.