Much has been written about the Canada Revenue Agency’s plans to review leveraged insurance arrangements, also known as 10/8 programs. These programs typically have the following characteristics:
- An individual acquires an “exempt” insurance policy to fund estate or succession liquidity needs.
- In addition to the cost of insurance charges, the policyholder makes additional deposits into the insurance policy that accumulate on a tax-deferred basis.
- The insurance company either provides a policy loan or underwrites the policyholder for a collateral loan and accepts the insurance policy as security.
- Deposits within the insurance policy that support the loan are transferred into a special investment account that guarantees that the credited interest rate will equal the loan interest rate less 2%.
- The current interest rate on such loans is 10%, which results in a credited interest rate of 8% to the cash value of the policy supporting the loan.
Why would a policyholder enter into this type of loan arrangement? The answer lies in the fact that if the money is borrowed to earn business or investment income, the interest is deductible against the borrower’s income. So for a borrower in a 45% tax bracket and paying 10% interest on the loan, the after-tax cost of the borrowing will be 5.5%. At the same time, the insurance policy is growing at a rate of 8%, and the policyholder can receive additional loans secured by the growth in the cash value. This may create a positive cash flow to the borrower on an after-tax basis.
The tax treatment of these programs has recently received public attention as a result of comments made by CRA officials at the 2008 Canadian Tax Foundation meeting. The CRA indicated that its General Anti-Avoidance Rule (GAAR) committee had recently reviewed a 10/8 program and could not confirm that the policyholder was entitled to claim the 10% interest deduction. But the CRA went on to state that it has not come to a final conclusion on these programs, and invited interested parties to put forward submissions on different products for its review.
There has been some conjecture as to why the CRA may not have given a “clean” GAAR opinion on the interest expense deduction. Possibly, the CRA takes the view that the borrowed money was in fact used to purchase the insurance policy, and not for income-producing purposes. However, the Supreme Court of Canada (SCC) decisions in Singleton , and more recently Lipson , affirm that taxpayers may organize their affairs to use personal capital to acquire non-income-producing assets, and borrow capital to acquire assets for investment purposes. By doing so, the taxpayer can deduct the interest expense on the borrowed funds.
It has also been suggested that the CRA may be concerned that there is a tax advantage from the use of an exempt insurance policy as security for the loan, which is growing on a tax-deferred basis. It should be noted that the growth in such policies is subject to a special 15% tax at the insurance company level, which is meant to be a proxy tax on the policyholder.
But more importantly, the income-earning test in the Income Tax Act applies to the use to which borrowed funds are put. For example, where an individual takes out a loan secured by a mortgage on his or her home and uses the borrowed money to acquire an income-producing property, the interest on the loan is tax deductible. It is irrelevant that the personal residence that is assigned as collateral security for the loan is not an income-producing property, and that its future growth may be sheltered by the principal residence exemption. Similarly, the fact that the property assigned to the insurance company to secure the loan is an exempt life insurance policy should have no bearing on the question of interest deductibility.
Others have indicated that the 10% interest rate may be considered “unreasonable” by the CRA. However, the special and unique features of these loans justify a significant interest rate premium over rates charged on typical floating rate policy loans or collateral loans that do not include these features. For example:
a) The policyholder may borrow up to 100% of the policy’s cash value, and there are no restrictions on the timing or the amount of advances that may be taken, subject to the overall credit limit and security requirements.
b) Any amount outstanding under the loan may be repaid at the borrower’s discretion at any time, and from time to time, without bonus or penalty.
c) Advances, whenever made during the term of the loan, bear interest at a rate that is fixed and guaranteed at the commencement of the policy loan or loan term. In the case of collateral loans, the guaranteed interest rate is normally established for a 10-year term, and may be renewed based on lending terms and rates available at that time.
As well, the SCC has previously stated that “an interest rate established in a market of lenders and borrowers acting at arm’s length from each other… is generally a reasonable rate.” The CRA would therefore have a high legal burden to overcome to establish that the interest rate in these circumstances is not “reasonable.”
For anyone familiar with these programs, it is clear that significant efforts have been expended by the insurance companies to ensure they comply with the applicable legal, regulatory and income tax rules. So despite the concerns expressed by the CRA, there is a high degree of confidence that properly structured and implemented insurance leveraged programs will continue to withstand any CRA scrutiny.
Kevin Wark, LLB, CLU, TEP, is senior vice-president, business development at PPI Financial Group.