Insured Annuity Strategy General Issues

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1 February 7, 2005 Insured Annuity Strategy General Issues Additional considerations that apply to corporations, individuals or trusts Tax Hélène Marquis, LL.L., D. Fis., Pl. Fin, TEP Senior Planning Consultant Wealth Protection Group Sun Life Financial In Brief It is important to be aware of general issues (i.e. cash flow, deductibility rules and forms of protection) that apply when implementing the Insured Annuity Strategy for corporations, individuals or trusts. NOTE: Specific information on how the Insured Annuity Strategy is applied to corporations and to individuals and trusts is available in past issues of Advisor Notes. 1 Cash Flow Leveraged Loans Cash flow can have an impact on how the Insured Annuity Strategy is structured. For example, the client may lack liquid non-registered funds or prefer to maintain an existing investment portfolio. In these instances, the Insured Annuity Strategy may be partially or fully financed through a leveraged loan. This is known as the Leveraged Insured Annuity Strategy or the Triple Back-to-Back Strategy. 1 See Corporate Insured Annuity Strategy, January 10, 2005 and Insured Annuity Strategy for Individuals and Trusts, January 25, 2005.

2 With this strategy, the money borrowed from a financial institution (e.g. bank, credit union or insurance company) is used for one of two purposes: 1) To purchase the annuity contract itself, or 2) To replace capital withdrawn from an -generating portfolio that was used to purchase the annuity contract. In either case, both the life annuity contract and the life insurance policy are assigned to the financial institution to secure the loan using a collateral assignment. 2 Assigning an annuity contact and a life insurance policy to secure a loan is not a taxable disposition for the purposes of the Income Tax Act (ITA). 3 Tax Considerations Premium Deductibility Although premiums payable to buy a life insurance policy are usually not deductible, a portion of the premiums that is the lesser of the premium paid or the Net Cost of Pure Insurance (NCPI) can be deducted against from property or a business taxable as long as: a collateral assignment exists with a qualifying financial institution, and the taxpayer is also the policy owner, and the assignment of the policy is a condition of the loan. NOTE: The premium used to initially purchase the annuity contract (whether borrowed or existing funds) is never tax deductible. 4 2 In Québec, a loan is secured by providing a moveable hypothec (art et seq. Q.C.C.). However, the method to implement the hypothec differs depending on whether the borrower is an individual or a corporation. 3 Ss 148(9) disposition ITA 4 Para. 20(1)(e.2) ITA 2

3 Interest Deductibility When money is borrowed to purchase a non-registered annuity contract, the interest paid on the loan is deductible as long as: the contract is not a prescribed annuity, it has been acquired after 1989, and the accrual is taxed annually under S ITA. The amount of the deduction is limited to the taxable portion of the annuity 5. When money is borrowed to replace an investment portfolio that earns interest and dividend, the interest paid on the loan is usually deductible under current Federal tax rules 6. NOTE: Interest paid on funds borrowed to purchase a life insurance policy is never tax deductible, even when the policy is bought for investment or business purposes. 7 Forms of Protection Creditor Protection Corporate-owned contracts are not protected against seizure from the corporation s creditors. For individuals and trusts, both an immediate annuity contract sold by an insurer and a life insurance policy are usually protected against seizure from creditors as long as an eligible beneficiary designation is made at the right time 8. At death, the life insurance proceeds are protected against the creditors of the deceased s estate, but not against those of the beneficiary. NOTE: Creditor protection does not exist when the annuity contract and the life insurance policy are collaterally assigned to secure a bank loan. 5 Para 12(1) )(c) ITA 6 Detailed information on the Federal tax rules is provided in the reference paper Interest Deductibility, available at It is important to be aware that in its March 22, 2004 budget, the government of Québec proposed measures to limit the interest deductibility on money borrowed to earn from an investment portfolio to the amount of taxable generated. This measure became effective on March 30, Para 20(1)(c) ITA 8 The reference paper titled Creditor Protection provides detailed information on life insurance and annuities creditor protection. The paper is available at 3

4 Protection Against Insurer Bankruptcy When a life insurance company is a Compcorp member, its clients are protected against the failure of life insurance and life annuity contract issuer. For an annuity payout, the protection is not less than $2000 monthly and can be up to 85% of the payout in excess of the first $2000. The life insurance policy death benefit is covered up to $200,000. An additional coverage up to 85% of the promised benefit is available when the total coverage exceeds $200,000. Policy cash value and accumulated value benefits are also protected up to $60,000. Additional information regarding Compcorp protection is available at Case Study Paul and Diana are both 63 years old. They are considering a Leveraged Insured Annuity Strategy to increase both their lifetime stream and their estate value without affecting their existing portfolio. Their investment portfolio is worth $2,000,000. They will invest $200,000 and borrow $785,000 from a qualified financial institution to buy the annuity contract. The first year life insurance premium will be paid from their current. The bank has requested a collateral assignment of the $1M life insurance policy and the annuity contract to secure the loan. Assuming a portion of the NCPI is tax deductible, the table on the following page demonstrates the value of the strategy. NOTE: The amounts presented in the following table are based on Sun Life annuity rates in effect on January 17, The annual life insurance premium is the annual minimum deposit for a SunUniversalLife joint life, last-to-die policy with premiums payable to the last death. Negative returns in an equity index account could result in the policy owner having to pay additional deposits to keep the insurance in force. The use of guaranteed interest accounts is recommended for this strategy in order to avoid this potential problem. 4

5 Leveraged Insured Annuity Strategy Investment Portfolio Leveraged Insured Annuity Year 2 Year 10 Investment $10,000 Non-prescribed annuity $65,598 $65,598 A Taxable portion $10,000 Taxable portion $48,273 $41,174 Loan interest deduction ($39,250) ($39,250) NCPI deduction Yr.2 = 78.5% x $2,898 Yr.10 = 78.5% x $10,920 ($2,275) ($8,573) Total tax deduction ($41,525) ($47,823) B Net taxable annuity $6748 nil Tax 48.2% $4,820 Tax 48.2% ($3,253) nil Net after-tax $62,345 $65,598 Life insurance premium ($14,184) ($14,184) Interest payable on loan ($39,250) ($39,250) C Net $5,180 Net $8,871 $12,124 Investment 5%) $39,250 Investment 5%) $39,250 $39,250 Taxable portion $39,250 Taxable portion $39,250 $39,250 Tax 48.2% ($18,919) Tax 48.2% ($18,919) ($18,919) Net $20,331 Net $20,331 $20,331 Total net $25,511 Total net $29,202 $32,455 A The first annuity payout is made one year after purchase of the annuity. B While the interest expense deduction is limited to the taxable generated by the annuity, the NCPI deduction is limited to an amount that is considered to reasonably relate to the amount owing on the loan. Since no capital reimbursement occurs, the amount of the deduction is the full eligible portion of the NCPI as long as it does not exceed the premium paid. C Since $785,000. was borrowed to buy a non-prescribed annuity contract the interest paid on the loan is deductible up to the taxable generated by the annuity contract. 5

6 Advising Clients The Leveraged Insured Annuity Strategy may be appropriate for: Retired clients who wish to implement a succession plan; Clients who seek to increase both non-taxable during their lifetimes and their estate value at the time of death; Clients age 60+ who wish to stabilize and secure a portion of their retirement while preserving estate value. This strategy is best suited to clients who are comfortable with complex legal, tax and financial concepts. The deductibility of interest and investment fees must be considered very carefully, as this has a significant impact on the overall profitability of the strategy. The annuity and the life insurance contract must each be subject to a separate underwriting process. Otherwise, the CRA may consider them as one non-exempt contract which would significantly reduce the after-tax value of the strategy. Implementation of this type of strategy must be based on strict adherence to the basic principles of insurance and investments i.e., the need for coverage must be met and the client s investor profile and risk tolerance must also be taken into consideration. For Advice and Support Call SUN ( ), option 5 (for Regional Distribution Offices), then select: 1. Vancouver (BC) 2. Calgary (AB, SK, MN) 3. Waterloo (ON) 4. Toronto (ON) 5. Montreal (QC, NB, NS, PE, NL) Advisor and client information is available on the Sun Life Financial Advisor site at The information presented here is for your information only. Sun Life Assurance Company of Canada does not provide legal, accounting, taxation or other professional advice to advisors or their clients. Before you act on any of this information on behalf of a client, always have your client seek advice from a qualified professional including a thorough examination of your client's specific legal/tax situation. 6

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