New rules - tax changes impact on insurance planning in Canada
Recent and proposed changes to the federal Income Tax Act (the Act) will affect the way insurance products are designed, and insurance planning generally. Moreover, the Canada Revenue Agency (CRA) has published new interpretations of the tax treatment of planning arrangements that involve life insurance. This article will discuss how these changes will alter insurance planning for Canadians, both now and in the future.
Exempt test legislation
The ‘exemption test’ in regulation 306 of the Act sets out the amount of savings in an insurance policy that can accumulate on a tax-deferred basis. An exempt policy is exempt from the accrual tax rules in s12.2 of the Act. Moreover, the payment of a death benefit from an exempt policy, including any tax-deferred accumulated values, is not a disposition for the purposes of s148 of the Act, which means the payment is received tax-free by the beneficiary or the estate of the policyholder.
Draft legislation that will change the rules for exempt policies was released for comment on 23 August 2013. These rules are evolutionary rather than revolutionary, and will not have a significant impact on many traditional life-insurance applications. Under the new rules:
- Early-year accumulations will increase and longer-term accumulations will decrease.
- Short-pay policies will be eliminated.
- An anti-avoidance rule will be introduced, which will allow the CRA to challenge transactions on the basis that they were made to take advantage of the exemption test.
- The investment income tax (a proxy tax on the accumulations within an exempt policy) will be higher on universal life level cost of insurance products.
- New mortality tables will be introduced to determine the ‘net cost of pure insurance’ of an insurance policy (which is relevant for determining the adjusted cost basis (ACB) of the policy) and the capital portion of payments under a prescribed annuity contract (resulting in a higher taxable portion).
Advisors and their clients may still review and make necessary changes to life insurance coverage, since the new measures will generally affect only policies issued after 2015, with extensive grandfathering for policies issued before then.
A 10/8 programme is essentially a universal life insurance policy with a special investment account that is used to secure a loan from the insurer. The policyholder borrows from the insurer (as either a collateral loan or a policy loan) against the value of the special investment account, and the interest rate on the borrowing is set at, say, 10 per cent (currently 8–9 per cent). Money that is deposited into the special investment account is guaranteed to earn interest at 2 per cent less than the loan rate.
Various 10/8 programmes have been the subject of review and challenge by the CRA. The Department of Finance (Finance) decided to take steps to eliminate these programmes in the 2013 Federal Budget. Final legislation has now been released, with the following measures becoming effective after 2013:
- Denial of the interest deduction in paragraph 20(1)(c) of the Act.
- Denial of the collateral insurance deduction in paragraph 20(1)(e.2) of the Act.
- For policies with a corporate beneficiary, a reduction in the capital dividend account (CDA) credit (which arises from the insurance death benefit and permits the payment of tax-free capital dividends) by the amount outstanding, immediately before death, equal to the collateral borrowing that caused the policy to be a 10/8.
The new measures will apply whether an arrangement was entered into before or after the budget date. However, the impact of the new rules is delayed until 2014 to permit policyholders time to unwind 10/8s, either by repaying loans or by restructuring them to be ‘compliant’ loan structures.
The repayment of 10/8 loans under existing arrangements has been facilitated by a deduction for policy gains that are realised on withdrawals made from a policy to repay collateral loans, provided such a withdrawal is made from the special investment account after 20 March 2013 and before April 2014. Note, however, that the other adverse tax consequences outlined above will still apply from 1 January 2014.
Leveraged insured annuities (LIAs)
An LIA is an arrangement where funds have been used to purchase a life annuity and a life insurance policy, which are assigned as collateral for a loan that can be put to an eligible use. Under this arrangement, the borrower would deduct the loan interest expense and, if applicable, the prescribed amount under paragraph 20(1)(e.2). Also, where this arrangement is structured within a private corporation, the capital gain related to the deemed disposition of shares on death may be reduced, and a CDA would be created.
Finance has been concerned that LIA programmes were motivated primarily by tax benefits rather than financial advantages, which prompted it to change the rules for LIAs as of the date of the 2013 Federal Budget.
The final legislation confirms that the following measures will apply to LIAs:
- Interest will be deductible, subject to the limitations of paragraph 20(1)(c) of the Act.
- There will be no collateral insurance deduction under paragraph 20(1)(e.2) of the Act.
- The annuity premium will be included in determining the value of property (e.g. shares of the private corporations) held on death.
- The policies will be not be ‘exempt policies’ and will be subject to accrual tax.
- No CDA credit will be available on the payment of the insurance proceeds.
Grandfathering is provided for loan arrangements in place before the 2013 Federal Budget. The explanatory notes to the final legislation clarify that LIAs will not be subject to the new rules as long as the borrowing is not increased after 21 March 2013.
Retirement compensation arrangements (RCAs)
An RCA includes an arrangement under which contributions are made by an employer of a taxpayer in connection with benefits received in contemplation of that taxpayer’s retirement or loss of employment. RCA trusts can hold insurance as an investment, and recent structuring used insurance as collateral for loans to the RCA trust, which funds the RCA trust on-loaned.
The 2012 Federal Budget introduced new rules that say prohibited investment and advantage rules for RCAs, meaning any ‘advantage’ or ‘benefit’ that is conditional on the existence of an RCA, other than a payment out of an RCA, will be included in computing a taxpayer’s income. The prohibited investment rule does not apply to property acquired before the budget date. The advantage rule could apply to certain transactions after the budget date if they involve life insurance acquired before the budget date. These measures became law on 14 December 2012.
The new law also contains a transitional rule that allows an ‘offside’ loan to be rehabilitated by giving it ‘commercially reasonable’ terms. A rehabilitated loan would not give rise to an ongoing advantage for the RCA trust. The CRA has indicated that existing debts must be amended on or before 31 December 2013 by providing for the ‘commercially reasonable’ payment of principal and interest at least annually.
On a cautionary note, the CRA recently said an advantage may arise from the mere fact that an RCA trust holds insurance with a more than nominal death benefit, as the beneficiary would not benefit from insurance proceeds paid to the RCA trust on death. The basis for this view is unclear.
Insurance and trusts
Another fairly recent CRA interpretation is expected to affect the ownership of insurance in a spousal or alter ego/joint partner trust. Currently, transfers of capital property to these types of trusts can take place on a rollover basis, with any gains being deferred until the property is disposed of by the trust (such as on death, for a spousal trust).
The CRA has indicated that a trust’s ownership of insurance may ‘taint’ the rollover of capital property to the trust on the basis that someone other than the spouse may become entitled to the income or capital of the trust before the death of the spouse. However, the fact that the trust could be the beneficiary (and not the owner or premium payor) of the policy would not taint the trust. At the 2012 annual meeting of the Conference for Advanced Life Underwriting, the CRA was asked to comment on a situation where a private corporation owned life insurance on a surviving spouse, and the shares of the corporation were transferred to a spousal trust. The CRA would not confirm that such a transfer would not taint the trust. The insurance industry is concerned with this interpretation and will try to clarify the CRA’s views.
In summary, there is significant legislative and CRA activity that is affecting insurance planning strategies for Canadians. It is critical for advisors to be aware of these changes and to understand how they may affect clients who have or are considering the purchase of life insurance policies.
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