CRA unclear about policy on “10/8” products

Comments in recent months by the Canada Revenue Agency regarding so-called “10/8” leveraged-loan strategies have introduced a greater degree of uncertainty into the sale of these sophisticated insurance products, industry insiders say. And the comments have also led to some confusion as to why the CRA has targeted the structures for possible review, and what the agency’s next move could be.

At a conference in June, Wayne Adams, director general of income tax rulings with the CRA, followed up on comments he had first made in late 2008 regarding the CRA’s possible concerns with 10/8 strategies. But in June, he stopped short of indicating definitively what aspects of the structures concerned the CRA. Adams did, however, issue a clear warning to the financial services industry that 10/8 strategies remain on the CRA’s radar screen.

“If this is a product that your client has, or you’re inclined to recommend it to him, only do so with the full expectation that, again, you might have a chance to explain it to [the CRA’s] Appeals [Branch] and/or [Chief Justice Gerald Rip of the Tax Court of Canada],” Adams said at the annual conference of the Society of Trust and Estate Practitioners (Canada) in Toronto.

Industry insiders say they don’t believe the CRA’s comments have necessarily slowed the promotion and sales of 10/8 products, but they suggest the CRA’s intention is to introduce a chill while the agency decides on how it will deal with 10/8s.

“Clearly, the CRA is concerned about them, and it’s trying to slow down [the promotion of the products] before making a determination,” says Kevin Wark, senior vice president of business development with Toronto-based PPI Financial Group Inc. , a specialized managing general agency focusing on high net-worth clients, which sells 10/8 products.

As of Investment Executive’s deadline, the CRA had not responded to IE’s queries.

The 10/8 strategy, in its most basic form, involves a taxpayer buying an insurance policy (typically, a universal life policy) and then using that policy as security against a loan. Often, the insurance company and the lender are the same firm or are related companies. The investment component of the policy earns a set annual interest rate — typically, 8%. Meanwhile, the taxpayer takes out a loan at 10%, with either the policy representing the security (a collateral loan) or the loan coming out of the insurance policy itself (a policy loan). The taxpayer then invests the borrowed money in an “eligible” investment — an investment that would allow the taxpayer to deduct the interest on the loan on his or her income tax return.

The strategy’s structure allows the taxpayer to buy needed insurance while utilizing a tax-efficient leveraging strategy in order to invest the borrowed funds. Product sellers make a profit on the spread between the interest rate on the loan and that credited to the taxpayer’s policy, and on the sale of the insurance policy itself.

Industry professionals say 10/8 structures all have common features but can vary widely in their details. It’s those details that might determine which structures could pass muster with the CRA and those that might be vulnerable to an audit.

The borrowed money, for example, has to be invested toward an eligible use, which means: for the purpose of earning income from a business or property. Failure to convince the CRA of this could result in the deduction being disallowed.

Last December, at the annual conference of the Canadian Tax Foundation in Calgary, Adams announced that the CRA had received a request for a ruling on a particular 10/8 product. The product was considered by the CRA’s general anti-avoidance rule committee, but the agency declined to give the product a “clean” GAAR opinion; in effect, the CRA withheld its endorsement of the product.

Adams went on to say that the CRA would consider other 10/8 product submissions, but added that he thought it would be a difficult hurdle for someone to persuade the CRA that the taxpayer would be entitled to the interest expense in a 10/8 structure.

“The sense I got from that [December] announcement was that the CRA was mostly troubled by the ‘reasonableness’ of the 10%,” says Jillian Welch, Toronto-based partner with law firm Wilson & Partners LLP. The CRA might have thought the rate was too high, and indefensible commercially, she adds. “Technically, the CRA doesn’t need the GAAR in order to challenge an interest deduction it thinks is not reasonable.”

@page_break@Yet, when speaking at the STEP conference in June, Adams backed away somewhat from the comments he had made in December, acknowledging that “we might have been overly pejorative” regarding 10/8s in general and that the product reviewed by the CRA might not have been indicative of products sold by other firms. However, in June, Adams reiterated the CRA’s trouble with the interest deduction: “I still do not think that this is eligible for an annual recognition of 10% interest on the policy loan.”

But while the reasonableness of the 10% interest appears to be the primary sticking point for the CRA, observers say, no one can be certain how the CRA might challenge a particular 10/8 product. Will it be on the reasonableness of the 10% rate, or on the use of the borrowed money? Or might the CRA challenge the product under the GAAR? This lack of clarity is a source of frustration for those in the industry.

“The CRA has to get a better understanding of 10/8s,” says Wark, “and tell the industry what is not appropriate about them, and the industry will respond.”