Budget 2013: Knives are out for 10/8s

“There could be some negative implications to unwinding these for clients,” says Asher Tward, vice president of estate planning with TriDelta Financial Partners Inc. in Toronto. “That could bring about some dicey situations for brokers.”

So-called 10/8s have been the subject of Canada Revenue Agency (CRA) scrutiny for several years. A typical 10/8 strategy involves an individual purchasing a permanent life insurance policy and using that policy to secure a loan, worth up to 100% of the cash value of the policy, from the same insurance company that issued the policy.

Typically, the investment portion of the insurance policy in a 10/8 structure earns an annual interest rate of 8% and the interest rate on the loan is set at 10%. The 8% interest earned by the policyholder is tax-exempt as part of the investment portion of the policy, and the 10% interest payable on the loan is tax-deductible if the funds are used to invest in an eligible business investment under the federal Income Tax Act (ITA).

The net effect of the investment and the loan is a loss of 2% (10% interest paid minus 8% income earned). When taking into account the tax deduction, however, investors with a marginal tax rate of 45% are effectively generating a net benefit of 2.5% (4.5% tax savings minus 2% net cost).

“That extra money, essentially, is used to pay for the cost of the insurance,” says Tward. “The idea is that you’re getting free insurance and the government is paying for it.”

Policyholders also can generate additional gains if the borrowed funds earn a positive return on investment.

“For the right client, [the 10/8 strategy] was very attractive,” says Kevin Wark, president of the Conference for Advanced Life Underwriting in Toronto. “It put in place the insurance [the client] needed, allowed [the client] to grow the capital in [the policy] at a guaranteed rate, and leverage the policy at a guaranteed rate.”

The federal budget has introduced legislative measures to prevent the future use of 10/8 arrangements. Under the proposed changes, after 2013, policyholders with these arrangements will be denied: the deductibility of interest paid on the loan; 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.

Essentially, Tward says, the budget’s proposal removes all of the normal tax benefits of a life insurance policy for individuals using the policy as part of a 10/8 arrangement.

“[The feds] made it very punitive to continue with this program,” Tward says. “They’re saying they don’t even want these things to exist.”

Although the 10/8 strategy is not particularly common, it has become popular among high net-worth clients and business owners in the past 10 years. The biggest 10/8 providers include Toronto-based Transamerica Life Canada Inc., Toronto-based BMO Life Assurance Co., Quebec City-based Industrial Alliance Insurance and Financial Services Inc. and Toronto-based PPI Financial Group Inc. The 2013 federal budget estimates that the elimination of the program will generate taxation revenue of $260 million over five years.

Ottawa has been vocal about its concerns with 10/8s in recent years, with the CRA suggesting that such policies may be abusive under the ITA’s general anti-avoidance rule.

“[The feds] see it as a concocted strategy to glean tax benefits, and they don’t like that,” says Tward, who has never sold a 10/8 policy. Even though there’s nothing illegal about the strategy, he adds, “it’s a loophole.”

However, the CRA has struggled to make a successful case against 10/8s. In a significant decision in November 2011, the Federal Court of Canada blocked attempts by the CRA to obtain information from insurers about 10/8 policyholders, weakening the CRA’s case against 10/8s.

“The CRA had the view that this [strategy] was abusive, and may not have had the tools it needed to combat this [10/8] effectively,” says Wark. “So, I think [the government] felt it needed to support the CRA and effectively deal with the programs.”

Although the insurance sector is not entirely surprised that the government took action against 10/8s, there’s a sense that the feds went too far by essentially eliminating the whole program rather than targeting only the specific policies that might be considered abusive.

“What we seem to be getting is a ‘one type fits nobody’ type of response,” says Ron Sanderson, director, policyholder taxation and pensions, with the Toronto-based Canadian Life and Health Insurance Association Inc. “This may be excessive.”

The insurance sector is hopeful that the government will hold consultations before implementing the changes outlined in the budget.

“[The feds] could have got a more appropriate approach if there had been further consultation,” says Sanderson. “We certainly hope that there will be an opportunity to have further discussions with government and explain why this may not be the appropriate approach.”

In order to facilitate the unwinding of existing 10/8 arrangements, Ottawa is proposing to alleviate the tax consequences on withdrawals from insurance policies under 10/8 arrangements that are withdrawn in order to repay loans under the arrangement. This will allow clients to repay their loans using the cash inside the policy without facing the tax bill that normally would be associated with a withdrawal. This exemption will be valid until Jan. 1, 2014. Says Tward: “That means that people don’t have to find the money to pay the loan.”

Many clients with 10/8 arrangements are likely to cancel the underlying insurance policy altogether, as they’ll no longer have the tax benefit that was helping them afford the potentially hefty policy premiums.

But these clients could encounter another problem in unwinding the strategy: surrender charges. When a client cancels a life insurance policy within the first eight to 10 years of the policy, most insurance companies levy surrender charges, which can eat up a huge portion – potentially, all – of the cash inside the policy. Thus, clients who entered into 10/8 arrangements within the past decade may have to repay the loan out of their pockets, says Tward: “Because of surrender charges, there could be massive losses to investors.”

This could lead to legal issues for the advisors who recommended the policies, Tward adds: “If you’re taking a major loss because of surrender charges, and you’re now going to have to be out of pocket on this policy, and the broker made a massive commission, you better believe you’re going to sue. I think there could be some [errors and omissions] claims coming out of this.”

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