Most people recognize that life insurance can be used to create a tax-free death benefit to fund estate and succession liquidity needs. Less well known is the fact that additional deposits can be made into an insurance policy that will accumulate with interest on a tax-deferred basis (subject to limits set out in the Income Tax Act). If this accumulated cash remains in the policy until death, it can be added to the tax-free death benefit payable to the estate beneficiaries.

These attributes have made permanent life insurance attractive as collateral security for investment loans. The cash in the policy forms the security for the loan while the policyholder is alive. On death, the loan can be repaid from the tax-free death benefit (which also includes the policy’s cash value).

A number of insurance companies now provide policy loans or collaterally secured loans based on the security of their policies. Such programs allow the policyholder to borrow up to 100% of the policy’s cash surrender value, and guarantee the loan interest rate for 10 years or longer. The insurance companies also offer an investment account within the policy that guarantees the interest rate will equal the loan interest rate less 2%.

Given these and other unique loan features, it was determined that the loan interest rate should be higher than traditional policy loan or fixed-term credit facilities. As a result, most of the insurance companies have established a current loan interest rate of 10%, which in turn provides a guaranteed credited interest rate of 8% for the cash value of the policy supporting the loan.

Why would a policyholder enter into this type of loan arrangement? The answer lies in the fact that if the money is being borrowed to earn business or investment income, the interest is deductible against the borrower’s income. So, for a borrower in a 45% tax bracket and paying 10% interest on the loan, the after-tax cost of the borrowing will be 5.5%. At the same time, the insurance policy is growing at a rate of 8% (tax deferred) and the policyholder can receive additional loans secured by the growth in the cash value. This can create a positive cash flow to the borrower on an after-tax basis, which can be used for any purpose.

The tax treatment of these programs has recently received more public attention, as a result of comments made by Canada Revenue Agency officials at the 2008 Canadian Tax Foundation meeting. The CRA indicated that its general anti-avoidance rule (GAAR) committee had recently reviewed an insurance leveraging program (referred to as a “10/8” program), and could not confirm that the policyholder was entitled to claim the 10% interest deduction. But the CRA went on to state that it has not come to a final conclusion on these programs, and invited interested parties from the insurance industry to put forward submissions on different products for its review.

What are the possible concerns of the CRA with 10/8 type programs? First and foremost, the CRA will want to confirm that the borrowed funds are being used for qualifying investment purposes (i.e. to earn income from business or property). Thus, it is very important to ensure the borrowed funds can be traced into income-producing investments.

The CRA may also attempt to challenge the reasonableness of the 10% loan interest rate. As noted above, the terms of these loans offer a number of unique benefits to the borrower that would justify a higher interest rate. As well, the Supreme Court of Canada 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”.

Another possible concern is that the CRA may try to challenge these arrangements on the basis that the money is actually being borrowed to purchase a non-income producing asset, namely the insurance policy. However, the recent SCC decision in Lipson v. Canada endorsed “Singleton” type planning, which permits individuals to use personal capital for non income-producing purposes, and borrow capital for income-producing purposes to make the interest on such loans deductible for tax purposes.

The CRA has also commented on one 10/8 arrangement — that it appears the policyholder is paying only 2% interest on these loans. This is in reference to the ability of the borrower to take additional loan advances equal to the 8% growth in the policy. The CRA has in prior technical interpretations confirmed that it would consider the full interest to have been “paid” in such a case, and that the interest on such an advance would also be deductible provided the original loan meets the tests for interest deductibility.

@page_break@As with any arrangement that has tax attributes, there is the threat of a GAAR challenge by the CRA. The recent SCC decision in Lipson confirms the principles enunciated by the SCC in earlier GAAR-based challenges, including the principle that the onus is on the CRA to prove that such arrangements result in a misuse or abuse of the act. Assuming a bona fide need for insurance and the proper use of the funds for investment purposes, there is a high degree of confidence that a properly structured and implemented 10/8 program can withstand a GAAR challenge.

All of this, of course, points to the need for proper advice from insurance and tax planning professionals who are very familiar with these programs and the applicable tax rules.

Kevin Wark, LLB, CLU, TEP, is a senior vice president with PPI Financial Group.