The federal government has proposed to eliminate many of the tax advantages related to two leveraged life insurance strategies. The government says it acted in order to improve the integrity and fairness of the tax system. The government calculates that these measures will allow it to recover $360 million between now and 2017-18.The government began by attacking leveraged insurance annuities (LIAs). This type of contract provides for the use of borrowed funds in connection with a life annuity and life insurance which are both issued on the life of an individual. In this kind of arrangement, the life insurance policy usually covers the person for his or her entire lifetime, while the amount of the death benefit under the policy is equal to the amount invested in the annuity, and both the policy and the annuity are assigned to the lender who advances the loan.
These are integrated investment products and they are offered and sold as such. However, for income tax purposes, each element of a leveraged insurance annuity is treated separately. “As a result, investors in leveraged insured annuities are provided with multiple tax benefits that are not available in relation to comparable investment products,” reads the Budget document.
Unintended tax benefits
The 2013 budget is eliminating these unintended tax benefits by introducing various rules for what it refers to as “LIA policies”. The government says that a life insurance policy issued on the life of an individual will be deemed to be an LIA policy if:
- a person or partnership becomes obligated on or after Budget Day to repay an amount to another person or partnership (the lender) at a time determined by reference to the death of the individual; and
- an annuity contract, the terms of which provide that payments are to continue for the life of the individual, and the policy are assigned to the lender.
According to the Notice of Ways and Means, income accruing in an LIA policy will be subject to annual accrual-based taxation, no deduction will be allowed for any portion of a premium paid on the policy, and the capital dividend account of a private corporation will not be increased by the death benefit received in respect of the policy. In addition, the Budget document says that, for the purposes of a deemed disposition on death, “the fair market value of an annuity contract assigned to the lender in connection with an LIA policy will be deemed to be equal to the total of the premiums paid under the contract.” The government expects to recover $100 million with this mesure between now and 2017/2018.
10/8 strategy also hit
The federal government is also going after 10/8 arrangements, which involve investing in a life insurance policy in order to borrow on the security of this investment to generate an annual interest-expense tax deduction over a long period (i.e., until death of the individual whose life is insured under the policy). Without these tax benefits, the government says there would be no investing or borrowing.
In a 10/8 arrangement, a taxpayer (usually an individual or a corporation with a few shareholders) generates an annual deduction for interest expense by entering into transactions that result in a circular flow of funds. More specifically, the taxpayer invests funds in a life insurance policy. He then borrows an equivalent amount and the loan is secured by the policy or by an investment account in respect of the policy. The taxpayer then invests the borrowed amount in income-producing assets (so that interest paid or payable on the amount borrowed is deductible for tax purposes).
Under the 10/8 arrangement, the taxpayer pays interest expenses on the borrowed amount and earns interest income on the amount invested in the policy. The interest rate earned by the taxpayer (usually 8%) on the amount invested in the policy is equal to the rate of interest payable on the loan (usually 10%) minus a fixed amount (usually two percentage points). The taxpayer claims that the interest expense on the borrowed amount is deductible, while interest income on the amount invested in the policy is not included in income (since it is an exempt policy for income tax purposes).
To maximize the annual deduction of interest expenses, the total amount borrowed is increased by repeating the operations described above each year for a number of years and applying a high interest rate to the amount borrowed. 10/8 arrangements may also provide other unintended tax benefits, such as an annual tax deduction for a portion of the premiums paid under the policy and an increase, up to the total amount borrowed, in the capital dividend account of a private corporation that is a beneficiary under the policy.
The Government is already challenging 10/8 arrangements under the current provisions of the Income Tax Act. “Since these challenges are both time-consuming and costly, the Government is also acting now to introduce legislative measures to prevent 10/8 arrangements from being used in the future,” reads the Budget document.
The government is proposing to prevent unintended tax benefits from becoming available in relation to 10/8 arrangements. For tax years ending on the date of the budget or thereafter, if a life insurance policy or an investment account under the policy is assigned as security on a borrowing, and either the interest rate payable on an investment account under the policy is determined by reference to the interest rate payable on the borrowing, or the maximum value of an investment account under the policy is determined by reference to the amount borrowed, then the government says that the following income tax benefits will be denied:
- 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. >
Termination of existing arrangements
To facilitate the termination of existing 10/8 arrangements before 2014, the 2013 budget proposes to alleviate the tax consequences of making a withdrawal from a policy under a 10/8 arrangement that is made to repay a borrowing under the arrangement provided the withdrawal is made on or after Budget Day and before the first of January, 2014. The government expects to recover $260 million with this mesure between now and 2017/2018.
The section of the Budget documents relating to 10/8 arrangements concludes by saying that the government “will monitor developments in this area and, if structures or transactions emerge that undermine the effectiveness of the measure, evaluate whether further action is warranted, with possible retroactive application.”