Complex insurance strategies need extra care
David Christianson, BA, CFP, R.F.P., TEP
This article is aimed at insurance professionals, business owners who have corporate-owned insurance and potential purchasers of life insurance using a strategy which involves borrowing.
The Canada Revenue Agency (CRA) is currently conducting a review of the “exempt test” - the set of rules that determines whether or not a life insurance contract is tax exempt. In a minute we will review this.
A more immediate concern is a recent change in CRA administrative policy on the tax treatment of certain arrangements of corporate-owned life insurance. This change was articulated at a Canadian Tax Foundation Roundtable held with CRA late 2009. The detailed reference is found in a CRA document with the informative name of 9824645.
This change only relates to situations where a corporation owns a life insurance policy and pays the premiums on it, but that corporation’s parent company is the beneficiary of the policy, and the life insured is the owner of the parent company.
One of the biggest advantages to having a tax-free death benefit paid to a corporation is that that death benefit increases the capital dividend account (CDA) available to the corporation. This is an amount that can be paid out to the shareholders tax-free. A larger CDA allows more retained earnings to be distributed without tax.
You can see that in this situation, there would be a benefit for the parent company to receive the life insurance proceeds, for CDA, as well as the cash. This ability to increase the CDA is fertile ground for a number of corporate-owned life insurance strategies.
Naturally, there is a section of the Income Tax Act - subsection 15(1) – which makes taxable certain benefits bestowed by a corporation on its shareholders. In the past, CRA has taken the position that 15(1) would not apply in the life insurance example given above, according to Kevin Wark of PPI Financial Group, a well know specialist on the taxation of life insurance, in his presentation to the Society of Trust and Estate Practitioners in June, 2010.
However, CRA is now stating that subsection 15(1) will apply in this situation, if the ownership and beneficiary designation was structured to “unduly increase” the CDA. This will apply to new policies effective January 1, 2010 and for existing policies, effective January 1, 2011.
There are some potential solutions, but these require expert advice.
Life Insurance Exempt Test
Virtually all life insurance policies sold in Canada are of the “exempt” class, which means that tax on investment income earned within the policy is tax-deferred, subject to certain limits. (This limit is referred to as the “MTAR” line, which limits the amount of cash that can be deposited into a policy in any given year.)
In return, however, an insurance company pays a tax called the Investment Income Tax, equal to 15% of the assumed investment income on its exempt policies. This is built into the cost structure of the life insurance policies.
The news is that the Dept. of Finance is undertaking a review of the exempt test. They are concerned about certain products and strategies that have developed since the current test was developed in the 1980s.
No reason to panic, as it is expected that the tax exempt principle will remain intact, and any changes will apply only to new policies, not to those already in force.
One strategy that continues to come under CRA scrutiny is the so-called “10-8 strategy.” In this, an insurance company guarantees an 8% return to the policyowner on an amount equal to the amount borrowed inside the policy at a rate of 10%. The loan proceeds are then used to make eligible income-producing investments outside the policy, thus making this loan interest tax-deductible.
Since the 8% return is tax-deferred, there is a net after-tax gain for the policy owner, which helps offset the cost of insurance.
In 2008, CRA stated it was considering challenging such arrangements under the General Anti-Avoidance Rules, but appeared to back down from that in late 2009 and instead said that it would examine each case individually. Anyone involved in such an arrangement should be very careful to comply with the current rules on interest deductibility and eligible investments.
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David Christianson is a fee-for-service financial planner and portfolio manager, whose team at Wellington West Total Wealth Management Inc. provides comprehensive financial advice and management. You can e-mail him at dchristianson@wellwest.ca or visit his website at www.davidchristianson.com.