Feds release rules ending 10/8s

Both strategies, used primarily by sophisticated high net-worth clients, involve using loans and life insurance policies (and annuities, in the case of LIAs) to create tax advantages for policyholders. Clients with LIAs have less to worry about than those with 10/8s, since individuals who had LIAs in place prior to Budget Day will be grandfathered under the proposed legislation.

Clients with 10/8s must unwind them by the end of 2013. As the deadline approaches, insurance companies that previously offered 10/8s are scrambling to come up with options that preserve the policies in ways that don’t violate the new rules.

A typical 10/8 strategy involves purchasing a permanent life insurance policy with an investment component, and using that policy to secure a loan. The investment portion typically earns interest at 8%, with the rate on the loan set at 10%. The 8% policy interest is tax-exempt. The 10% interest on the loan is tax-deductible if the funds are used to invest in an eligible business investment under the Income Tax Act.

The net effect of the two rates is a loss of 2%. However, when taking into account the tax deduction, investors with a marginal tax rate of 45% effectively generate a net benefit of 2.5% (4.5% tax savings minus 2% net cost).

Under the proposals, the following arrangements will be denied after 2013: the deductibility of the loan interest; the deductibility of a premium paid under the policy; and, for policies owned by corporations, the increase in the capital dividend account by the amount of the death benefit that becomes payable under the policy.

These changes spell the end for 10/8s, according to Asher Tward, vice president of estate planning with TriDelta Financial Partners Inc. in Toronto. “The minute you lose the tax deductibility,” he says, “you’re now losing 2% a year on that loan. Plus, you have to put in fresh premiums every year. It has to be unwound.”

In theory, clients could simply pay back the loan to unwind the strategy. To facilitate this, the government has proposed that clients may withdraw the investment component of the insurance policy under a 10/8 arrangement, tax-free, to repay the loan until the end of 2013.

The problem, according to Tward, is that clients who set up their policies within the past eight to 10 years could face hefty surrender charges on this type of withdrawal. These charges can eat up a huge portion – potentially, all – of the cash inside the policy, leaving the client with a large loss on the original investment. “Even though the tax issue has been negated until the end of the year,” Tward says, “the surrender charges could be a huge problem.”

Of the insurers that have offered 10/8s, Toronto-based PPI Financial Group Inc. has been the only company so far to introduce an option that it says will allow clients to maintain their insurance coverage and loans in a compliant manner. PPI’s new offering, which was developed in collaboration with Quebec City-based Industrial Alliance Insurance and Financial Services Inc. and will be available in January 2014, is a managed investment account within a universal life policy providing the option to take out a loan backed by the policy. The loan rate will be based on the return of the managed account, plus a spread. According to PPI, clients with 10/8s will be able to convert their existing insurance policies and loans to the new compliant structures seamlessly.

PPI says the policy is compliant for two reasons: policyholders will be permitted to invest in the policy investment accounts without being required to take out a loan and the interest rate credited annually to the investment account will not be determined using the rate charged on a loan.

Both the interest rate on the loan and the rate of return in the managed account will be lower than the rates typically offered on 10/8s. Nonetheless, PPI says, the rates will be appealing to policyholders.

Given Finance Canada’s aggressive stance on 10/8s, however, some insurance-sector players suspect the use of alternative strategies such as this one may not be permitted. Tward says that although he’s not familiar with the details of PPI’s new offering, he doubts Finance Canada will be comfortable with any tax planning strategy that has features similar to a 10/8: “If the tax hit to the government is fundamentally the same, they’re going to shut that down, too.”

Another 10/8 provider, Toronto-based Transamerica Life Canada, plans to reveal alternative options once the budget legislation is passed, according to Doug Brooks, the firm’s president and CEO. In the meantime, he urges clients with 10/8s to sit tight. “At this time, we are recommending that policyholders don’t take any action other than remain aware that they should speak to their advisor about their particular insurance coverage and tax planning situation before the end of the year,” says Brooks. “We will have alternate options available in sufficient time for people to act before January 1, 2014.”

All insurers that offered 10/8s are under pressure to provide clients with solutions to prevent them from encountering hefty losses, says Byren Innes, senior vice president and director with Toronto-based NewLink Group Inc. “They’ll do something so that it’s not a catastrophe for the clients,” he says. “It may not be very pretty for the clients, but it’s not going to be a total horror story.”

Meanwhile, clients with LIAs – less common than 10/8s – will be able to leave those strategies in place. LIAs set up after Budget Day, however, will be denied various tax benefits, including those outlined above.

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