TAX NEWS - June 2010

Canada Tax: Complex insurance strategies need care

This article is aimed at insurance professionals, business owners who have corporate-owned insurance and potential purchasers of life insurance using a strategy that involves borrowing.

The Canada Revenue Agency (CRA) is reviewing the "exempt test" -- the set of rules that determines whether a life insurance contract is tax exempt. In a minute, we will review this.

A more immediate concern is a recent change in Canada Revenue Agency (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 in late 2009. The reference is found in a Canada Revenue Agency (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 the 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 capital dividend account (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 capital dividend account (CDA), as well as the cash. This ability to increase the capital dividend account (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) -- that 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-known 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 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 Jan. 1, 2010, and for existing policies, effective Jan. 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 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 the Investment Income Tax, equal to 15 per cent of the assumed investment income on its exempt policies. This is built into the cost of the life insurance policies.

The news is the Department of Finance is reviewing the test. It is concerned about certain products and strategies that have developed since the test was developed in the 1980s.

No reason to panic, as it is expected the tax exempt principle will remain intact, and any changes will apply only to new policies.

One strategy that continues to come under CRA scrutiny is the so-called "10-eight strategy." In this, an insurance company guarantees an eight per cent return to the policy owner on an amount equal to the amount borrowed inside the policy at a rate of 10 per cent. The loan proceeds are then used to make eligible income-producing investments outside the policy, thus making this loan interest tax-deductible. Since the eight per cent 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 it would examine each case individually. Anyone involved in such an arrangement should be careful to comply with the current rules on interest deductibility and eligible investments.