The Canada Revenue Agency (CRA) announced last year that it would be reviewing leveraged insurance arrangements, commonly referred to as “10/8 programs.” This review is supposed to be part of a broader audit project relating to insurance company policyholder tax compliance.

Insurance leverage programs typically comprise the following characteristics:
1. An individual or corporation acquires an “exempt” insurance policy to fund estate, succession and business liquidity needs.
2. In addition to the cost of insurance charges, the policyholder makes additional deposits into the insurance policy, which accumulate on a tax-deferred basis. 3. The insurance company either provides a policy loan or, acting in its capacity as a lender, underwrites the policyholder for a collateral loan and accepts the insurance policy as security.
4. Deposits within the insurance policy that support the loan are transferred into a special investment account which guarantees the credited interest rate will equal the loan interest rate less 2%.
5. The current interest rate on such loans is 10%, which results in credited interest rate of 8% to the cash value of the policy supporting the loan.

One might ask why a policyholder would enter into this type of loan arrangement. Assuming the borrowed funds are used to earn business or investment income, the interest should be deductible against the borrower’s income. So for a borrower in the 45% tax bracket and paying 10% interest on the loan, the after-tax cost of the borrowing would be 5.5%. On the other hand, the policy values supporting the loan are growing at a guaranteed annual rate of 8% (tax-deferred), and the borrower can elect to take out additional loans secured by and equal to the increase in the policy’s cash value. This arrangement may therefore create a positive cash flow for the borrower on an after-tax basis, as well as minimize the risk that the growth of the loan will outpace the growth of the underlying security.

At the 2008 Canadian Tax Foundation meeting, a CRA of- ficial indicated the CRA’s 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 official went on to state that the CRA has not come to a final conclusion on these programs, and invited interested parties to put forward submissions on different products for its review.

It still isn’t clear what situation the GAAR Committee was asked to consider in determining whether the interest expense was deductible. This has left the insurance industry to conjecture as to the nature of CRA’s concerns with these programs. This article will review tax issues that might be raised by the CRA on a policyholder review, and discuss some of the arguments in favour of interest deductibility and the non- application of the GAAR.

The CRA will first want to con- firm that the borrowing complies with the interest deductibility provisions of the Income Tax Act (ITA). As an initial step, the borrower must establish that the borrowed money was being used for the purpose of earning income from a business or property. This is a factual test that involves tracing of the borrowed funds to an eligible use as defined in the ITA.

The interest deduction can be denied if the borrowed money has been used to purchase an insurance policy. Again, the actual use of the borrowed funds is critical. 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 to make the interest on such loan deductible for tax purposes.

Another consideration is whether any portion of the 10% interest could be disallowed on the basis that it is unreasonable. 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 notice, bonus or penalty.

c) Advances or loans, whenever made during the term of the policy loan or collateral 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.

In addition, the SCC in Shell Canada Limited v. The Queen has indicated 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.” This establishes the principle that the test of reasonableness for interest deductibility must be viewed in light of the amount that would have been charged in an open market for lending arrangements with substantially similar terms and conditions.

The CRA may also be concerned that there is a tax advantage from the use of an exempt insurance policy as security for the loan, since it is growing on a tax-deferred basis. It should be noted that the interest credited to 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 ITA 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’s irrelevant that the personal residence 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.

The CRA has also indicated, with respect to a 10/8 arrangement, that it appears the policyholder is only paying 2% inter-est on these loans. This is with reference to the ability of the borrower to take additional loan advances equal to the 8% growth in the policy, which can be used for any purpose including making further interest payments on the loan. On this point, the CRA has, in prior technical interpretations, confirmed it would consider the full interest to have been “paid” in such a case, and that the interest on such loan advance would be deductible provided the original loan continues to meet the test for interest deductibility.

This finally leads to a discussion of GAAR in relation to these types of programs. The recent SCC decision in Lipson confirms the principles established by the SCC in earlier GAAR decisions. In assessing whether GAAR can apply, the Court must review the following questions:

1. Is there a tax benefit? 2. Is there an avoidance transaction that results in a tax benefit (unless the transaction was undertaken primarily for bona fide nontax purposes other than to obtain a tax benefit)? and 3. Can the transaction reasonably be considered to result in a misuse or abuse of the ITA?

Space does not permit a full review of the various issues that can arise from an analysis of GAAR in relation to insurance leverage programs. However, assuming the policyholder has a bona fide need for insurance and the proper use of funds for investment purposes, the taxpayer should be able to establish there is not an avoidance transaction.

And even if the Court accepts there is a tax avoidance purpose, the CRA bears the onus of establishing that the program results in a misuse and abuse of the ITA.

In this regard, policyholders have always been able to deduct qualifying interest on loans advanced by a bank or other financial institution where the underlying security is the cash value of a life insurance policy. It isn’t clear why borrowing the funds from an insurance company would convert what would otherwise be an acceptable transaction into one that represents a misuse or abuse of the ITA. And if the Court has already determined the loan rate is “reasonable” under the interest deductibility rules, it’s difficult to understand how the Court could find differently under a GAAR analysis.

For anyone familiar with these programs, it’s evident that significant efforts have been expended by the insurance industry 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.