George F. Lengvari, Sr., Ph.D., LL.B., C.L.U.

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2 George F. Lengvari, Sr., Ph.D., LL.B., C.L.U. George Lengvari is Chairman, Lengvari & Associates Inc., Vancouver, B.C., President & CEO, John Wordsworth, CLU. Past President of the Chartered Life Underwriters of Montreal and Past Director of the Estate Planning Council of Montreal. Recognized as a pioneer of many products and life insurance concepts including Corporate Leveraged Life Annuities, Single Premium Life Insurance, Deferred Annuities and interest-sensitive new money policies. Authored articles and lectured on life insurance (University of Montreal, Banff School of Fine Arts, Purdue University, and University of British Columbia and at conventions and conferences worldwide.) He has spoken on life insurance at the In-Depth tax course of the CICA. Acknowledgement I am indebted to Edwin C. Harris, LL.B. (Dalhousie), LL.M. (Harvard), F.C.A., Q.C., Counsel, McInnes Cooper, Halifax, for his valuable collaboration in the development of this publication. We owe a great deal of appreciation to John Wordsworth, CLU, President of Lengvari & Associates Inc., Vancouver, B.C., for his significant contribution to this article. Copyright George F. Lengvari Sr., 2007

3 I. Introduction... 1 II. Origin of the Exempt Policy... 1 III. Structure of the Exempt Policy...2 Preservation of Exempt Status... 3 a) Side Account...3 b) Cash Withdrawal...3 IV. Characteristics of Insurance...3 Temporary vs. Permanent Insurance...4 Participating VS. Non-Participating Insurance...4 Increasing (Face Plus) & Level Death Benefit...4 Level or Yearly Increasing Cost of Insurance...4 V. Types of Life Insurance...5 Term Insurance...5 Ten Year Renewable and Convertible Term...5 T Universal Life Insurance...5 Whole Life Insurance...6 VI. The Options: Evaluation and Comparison...7 VII. The Cost/Benefit Balance Analysis Ten Year Renewable And Convertible Term Insurance (Not Converted) Ten Year Renewable Term Converted (At Age 65) To Term To Age Term To Age Universal Life: Level Maximum Premium at 3 Percent Universal Life: Level Maximum Premium for Ten Years at an Assumed 8 Percent Investment Performance Universal Life: Ten Pay at 3 Percent Universal Life: Yearly Renewable Premium Whole Life: Level Maximum Premium at Current Dividend Whole Life: Level Maximum Premium for Ten Years at Current Dividend Retirement Compensation Arrangement (RCA)...12 VIII. Uses of Permanent Insurance IX. Leveraged Insurance X. Corporation-Owned Life Insurance XI. Advantages of Permanent Insurance XII. Conclusion... 18

4 Exempt Life Insurance: An Essential Tool in Tax and Estate Planning I. Introduction Life insurance has always been viewed as an essential element of estate planning. However, its utility as a method of tax planning and wealth preservation has often been overlooked and undervalued. Modern life insurance products offer beneficial and flexible planning opportunities to cater to a diverse range of needs. II. Origin of the Exempt Policy The concept of exempt life insurance was introduced as a consequence of the November 1981 Federal Budget. The proposals encompassed within the budget were met with a great deal of opposition from the life insurance industry as they purported to tax policyholders every three years on the accrued investment in their policies. As well, the proposed new legislation would tax corporate policyholders annually. Furthermore, the new legislation would be retroactive in its application. The concerns from the professional community resulted in a series of compromises. As a result, Bill C-139 amended the Income Tax Act, (the Act) and received Royal Assent on March 30, The Federal Budget in November, 1981 proposed that individual policyholders be required to report accrued income every three years on all life insurance policies. This was later changed to exclude grandfathered policies and exempt policies. The grandfathering provisions of the Act are complex, but suffice it to say that those policyholders who acquired their policies before December 2, 1982 continue to enjoy the same preferential tax treatment on the total investment in these policies as the more limited exempt policies subsequently issued. The government responsible for the Federal Budget in 1981 declared that single premium life insurance provided an undue tax advantage. The objective of this legislation was to restrict the amount of money that could be invested in a tax-sheltered life insurance policy. This goal was accomplished by placing a limit on the tax sheltered investment earnings in a life insurance policy as they relate to the overall death benefit under that policy. William J. Strain, Taxation of Life Insurance, (1995) 43 Canadian Tax Journal 1529.

5 Exempt Life Insurance: The purpose of the concept of an exempt policy is to ensure that an exemption from accrual taxation be provided for policies that have been acquired with the dominant purpose of insurance protection, rather than as an investment vehicle. 2 Regulations 306 and 307 to the Act (the Regulations) establish benchmarks to test whether a policy is an exempt policy or a disguised investment that should be subject to accrual taxation. To pass this test it must be established that the policy s accumulating fund does not exceed the accumulating fund of the benchmark exemption test policy defined in the Regulations. The accumulating fund used for the purpose of the exemption test policy is set out in Regulation 307. It can be summarized as: [t]he value of a sinking fund growing at an assumed interest rate minus the cost of insurance that would be required to equal the face amount of the policy at age 85. The accumulating fund of the exempt test policy is based on the interest rates and mortality charges used by the insurer in designing the actual policy. 3 The exemption test policy is defined in subsection 306(3) of the Regulations. The amount that can be deposited into an exempt policy is found in paragraphs 306(3)(d) and 307 (1)(c) of the Regulations and is based on an endowment at age 85 policy with a 20 year premium payment schedule. Deposits are further restricted by paragraph 306(4)(b), which prevents lump sum deposits after the policy s seventh anniversary date. This rule limits the rate of growth of the accumulating fund of a policy. If on the tenth or subsequent policy anniversary, the accumulating fund exceeds 250 percent of the accumulating fund on its third preceding policy anniversary, then deposits into the policy are restricted. III. Structure of the Exempt Policy The base exempt insurance policy is a level (as opposed to increasing) death benefit, level premium policy, which accumulates little or no cash value. A level premium policy attempts to address the problem created under a pure insurance system where premiums are related to the mortality costs for the individual s age. Under this system premium payments rise dramatically with age and this tends to encourage cancellation of the policy at an older age as costs escalate, but ironically as need becomes more important. 4 The level premium system provides permanent insurance that is affordable throughout the individual s life. The premiums under an exempt life insurance policy have three components: 1) Expenses; 2) Mortality Charges; and 3) Investment. 2 Joel T. Cuperfain and Florence Marino, eds., Canadian Taxation of Life Insurance, third edition (Toronto: Carswell) 2006 at Ibid. 4 Cuperfain & Marino, supra note 2 at 25. 2

6 An Essential Tool in Tax and Estate Planning Expenses and mortality factor into the price of a premium as assumptions. The insurance company incurs expenses in issuing the policy. These expenses are factored into the cost of the product and it is assumed that each policy contributes towards these expenses. 5 Mortality is also used to determine the price of the policy. Mortality is the number of deaths that occur for a population over a period of time. 6 The expenses and mortality charges purchase the base protection; this charge is the base premium. The investment portion allows additional deposits within the exempt limits. A typical policy today has a level death benefit plus the tax sheltered accumulating fund (the cash value). Preservation of exempt status At each anniversary the policy s exempt status is tested. This determines the maximum deposit for the ensuing policy year. Insurers generally guarantee the exempt status of a policy and utilize a variety of options to ensure the policy remains exempt. a) Side Account The insurer can place excess funds, which would cause the policy to become non-exempt, into a side account, the growth of which is taxed annually. It can increase the death benefit by no more than 8% per annum, or the excess funds can be withdrawn from the policy in order to retain the exempt status. b) Cash Withdrawal When cash is withdrawn from the Cash Surrender Value of the policy, it may be included in the income of the policyholder. The taxable portion will be the portion of the Cash Surrender Value that is withdrawn less the Adjusted Cost Basis of the policy IV. Characteristics of Insurance Here we will highlight a few alternative characteristics of insurance including: Temporary insurance or permanent insurance, Participating insurance or non-participating insurance, Increasing and level death benefits and Level and yearly increasing cost of insurance. 5 Ibid at Ibid. 3

7 Exempt Life Insurance: Temporary vs. Permanent Insurance Life insurance products can be generally classified as either temporary or permanent. Simply put, temporary insurance provides temporary life insurance coverage for a specified time period. Temporary insurance will expire when the specified time period within the policy contract has elapsed; whereas permanent insurance does not expire and is intended to provide life insurance protection no matter when the death of the insured occurs. Participating vs. Non-Participating insurance Permanent insurance can be further classified as participating and non-participating. This is a straightforward distinction as holders of participating policies receive dividends from an investment account known as a participating (Par) account and holders of non-participating policies do not. Premiums paid for a participating policy are deposited in the participating account. After expenses, the balance is invested in a portfolio of investments, similar to a portfolio average account 7. The policyholder must make a choice regarding the level of risk he or she is prepared to accept when deciding on an appropriate policy. A typical participating and non-participating policy may offer the same amount of protection but the participating policy will have a higher fixed premium. This is because in the event that the policy generates favourable returns in comparison with the insurer s assumptions relating to mortality, expenses, lapse and interest, these amounts can be allocated to a participating policyholder in the form of a dividend. 8 Increasing (face plus) & Level Death Benefit Certain types of life insurance have level death benefits and others offer a choice between level and increasing death benefits. A level death benefit remains the same throughout the life of the insurance policy. An increasing death benefit will increase throughout the life of the policy depending on the investment return generated in the policy. Level or Yearly Increasing Cost of Insurance There are two types of cost of insurance - level and yearly increasing - that can be used to cover the underlying risk charge. Cost of insurance is assessed at underwriting and is averaged over the anticipated life expectancy of the insured. The cost of insurance is the same every year. Yearly increasing cost of insurance increases annually. With age and increased probability of death the cost of insurance increases rapidly and is charged at the new higher rate annually. This account may contain such investments as bonds or real estate and is managed by the insurer. Cuperfain & Marino, supra note 2 at 25. 4

8 An Essential Tool in Tax and Estate Planning Certain types of insurance offer the option to choose which cost structure the policyholder wishes to use; others do not. V. Types of Life Insurance There are various types of life insurance products, all possessing unique attributes as well as comparative advantages and disadvantages. The primary types of life insurance policies that will be discussed in our analysis are Term, Universal Life and Whole Life. Term Insurance Term insurance is not permanent insurance; it is non-participating and always has a level death benefit. The policy owner is covered for a predetermined period of time or to a set age. After that time or age the policy contract terminates unless it is renewed or converted. The death benefit is level for the life of the policy. In this article we refer to two types of Term insurance: Ten year renewable and convertible Term and Term to age 100 (T-100). Ten year renewable and convertible Term The policy owner is covered for a predetermined period of time, in this case 10 years. If the policy owner pays the required premium the policy will automatically renew at a higher premium level every 10 years. The owner can surrender the policy at any time. The policy allows for convertibility to permanent insurance without evidence of insurability at any time to the age specified in the contract. Coverage for this type of Term contract usually terminates between ages 75 and 85. T-100 T-100 insurance is permanent insurance and is non-participating and always has a level death benefit. It also has a level premium. As long as the premiums are paid the policy owner is covered to age 100. Universal Life Insurance Universal Life originally was called the unbundled Whole Life that showed the three elements of a Whole Life insurance policy: Expenses, mortality charges and investment. Universal Life insurance has a few general attributes that are noteworthy. It is permanent, non-participating insurance which offers a level or increasing death benefit and level or yearly increasing cost of insurance options. It is designed to meet the needs of policy owners requiring long-term financial planning, combining tax sheltered cash value accumulation with insurance protection. One of the central defining features of Universal Life insurance is its flexibility. Policyholders can decide how much money they wish to deposit into the policy within the exempt limits and 5

9 Exempt Life Insurance: can change this amount, take a premium holiday or even stop making deposits, so long as there are sufficient funds within the policy to cover the costs of keeping the policy viable. The Universal Life policy can have total death benefit increases which reflect increases in the policy s accumulated value. Where a policy has an increasing death benefit, this increase is a function of deposits above the minimum base premium and their investment growth. The excess deposits can be invested in a wide range of accounts from simple and compound interest Guaranteed Investment Accounts to daily interest and managed accounts, which give the policyholder the opportunity to obtain tax sheltered growth. This growth is reflected in the death benefit so that at death the basic death benefit plus the value of the tax sheltered accumulated investments are distributed tax free. Whole Life Insurance Whole Life insurance is permanent insurance which can be participating or nonparticipating and offers an increasing (face plus) death benefit. It also offers some flexibility in premium payment similar to the Universal Life policy; you can invest in the policy over and above the required minimum premium but within exempt limits. You do not have a choice as to your cost of insurance or range of investments as in a Universal Life policy. Whole Life has these basic characteristics: a level premium payment guaranteed cash values the right to receive dividends 9 The dividends produced by this policy are distributed on an annual basis out of the available surplus from the underlying par fund. 10 This is one of the most conservative options available. The performance of the policy is based on a complex formula that flattens out the portfolio performance. Thus, the assumed gains and losses are moderated. Dividends can be used to buy more insurance which in turn creates more cash value. This option is often called Paid Up Additions. 9 Ibid at Ibid. 6

10 An Essential Tool in Tax and Estate Planning VI. The Options: Evaluation and Comparison When considering the acquisition of a life insurance policy, there is a range of options available including: 1. Ten year renewable and convertible Term insurance Ten year renewable Term converted (at age 65) to Term to age Term to age Universal Life: level maximum premium at 3 percent 5. Universal Life: level maximum premium at 8 percent 6. Universal Life: ten pay at 3 percent 7. Universal Life: yearly renewable premium 8. Whole Life: level maximum premium at current dividend 9. Whole Life: level maximum premium for ten years at current dividend 10. Retirement Compensation Arrangement (RCA) For each option we briefly describe the policy, and then show the cost/benefit balance on policy maturity at death. The cost/benefit balance of each option is based on a $1,000,000 initial death benefit for a healthy 45 year-old, non-smoking male policyholder. We assume death at normal life expectancy 12 at age 81, and then we assume death ten years later at age 91. VII. The Cost/Benefit Balance Analysis To compare financial results, we use the cost/benefit balance method. The cost/ benefit balance accurately illustrates whether a policyholder realizes a profit or a loss. The cost component of the analysis is the annual premium deposits, compounded by the policyholder s cost of money, which is the lower of: a) The loss of use of the invested capital (opportunity cost); and b) The cost of replacing the invested capital with borrowed money (replacement cost). We assume a 4 percent after-tax cost of money. The benefit is the death benefit. In this study we do not take into account the value of potential additional benefits such as the Capital Dividend Account. 11 Renewability and convertibility give the policyholder the right to convert to permanent insurance without evidence of insurability. 12 Normal life expectancy is the age at which there is a 50 percent chance of dying prior to and a 50 percent chance of living after. For a 45 year-old, healthy, non-smoking male there is an 85 percent chance of dying before 91 and a 15 percent chance of living longer. 7

11 Exempt Life Insurance: 1 Ten year renewable and convertible Term insurance (not converted) This policy produces a premium structure wherein the premium increases every ten years. Annual Premium Until Age First 10 years $1, Second 10 years $7, Third 10 years $20, Next 5 years $50, The Cost/Benefit balance: Age Cost $900,669 $1,333,210 Benefit Zero Zero Balance $(900,669) loss $(1,333,210) loss Note that in this example the insurance contract expires at age 80; thus, when the insured reaches life expectancy no death benefit is payable. 2 Ten year renewable Term converted (at age 65) to Term to age 100 We consider the conversion of the Ten Year Renewable and Convertible Term (Option #1) to a T-100 policy, occurring at age 65 (just before the end of the second ten year term). After conversion to the new T-100 policy, the new level annual premium is $28,930 payable for life (based on today s rates). The Cost/Benefit balance: Age Cost $875,910 $1,657,792 Benefit $1,000,000 $1,000,000 Balance $124,090 profit $(657,792) loss 8

12 An Essential Tool in Tax and Estate Planning 3 Term to age 100 Where a Term policy has a level annual premium (a premium guaranteed never to change) the cost/benefit analysis for a $1 million death benefit for the male 45 with a premium of $6,980 results in a profit except at a very advanced age. Age 81 Return 91 Return Cost $563,302 $920,979 Benefit $1,000, % $1,000, % Balance $436,698 profit $79,021 profit If death occurs at the age of 100, assuming a 4 percent after-tax cost of money, the accumulated cost is higher than the death benefit because the rate of return on death is only 3 percent. 4 Universal Life: level maximum premium at 3 percent The table below illustrates the cost/benefit analysis for a guaranteed level annual premium for life of $34,929, which shows the death benefit amount at life expectancy at age 81 and ten years later at age 91. Age 81 Return 91 Return Cost $2,818,849 $4,608,721 Benefit $3,405, % $5,185, % Balance $587,122 profit $576,554 profit There is a small profit even on death at 100. With a minimum 3 percent guarantee 13 at life expectancy, the policy generates a 4.86 percent return. This result is achieved because the policy has a bonus system, provided certain specific conditions are met. Bonus payments are designed to reward long-standing policy holders. Where a bonus is subject to a conditional guarantee the policyholder must satisfy preconditions in order to enjoy the bonus payment. 14 The bonus system used in this example generates 0.5 percent for 19 years and another 1.25 percent thereafter, for a total of 1.75 percent for the insured s remaining lifetime. 13 The 3% guarantee quoted is based on the deposit of the investment portion of the premium into an investment option that offers this guarantee. 14 Ibid at 43. 9

13 Exempt Life Insurance: 5 Universal Life: level maximum premium at 8 percent investment performance In this example, the annual premium for ten years is $33,124. After the tenth year the cost of insurance is paid from within the policy. Many Universal Life policies provide the policyholder with a wide range of investment options, which can give the opportunity for significant growth. Here we illustrate the results if the policy is credited with an 8% investment return over the life of the contract. Age 81 Return 91 Return Cost $2,673,181 $4,370,559 Benefit $4,152, % $7,155, % Balance $1,479,056 profit $2,785,097 profit 6 Universal Life: ten pay at 3 percent In this example, the annual premium for ten years is $34,929 Age 81 Return 91 Return Cost $1,209,173 $1,789,871 Benefit $1,664, % $1,962, % Balance $455,105 profit $172,496 profit After the tenth anniversary, the insurance cost is paid with pre-tax dollars from the tax-sheltered accumulating fund or cash value. The policy holder can resume making deposits within the exempt limits and subject to Regulation 306(4)(b). 10

14 An Essential Tool in Tax and Estate Planning 7 Universal Life: yearly renewable premium The premium for a Universal Life policy based on a yearly renewable Term (YRT) cost of insurance will increase annually because the cost will be based on the age of the insured. Under a Universal Life policy with YRT cost of insurance the policyholder pays only for the probability of death. Thus, at more advanced ages the premiums increase rapidly Year The Annual Premium Age 1 $7, $2, $4, $13, $33, $84, $ The cost/benefit balance for YRT cost of insurance and premium at ages 81 and 91 is as follows: Age Cost $1,067,464 $1,979,578 Benefit $1,039,462 $1,068,427 Balance $ (28,002) loss $(911,152) loss This clearly indicates that beyond life expectancy this type of insurance policy becomes prohibitively expensive. 15 The first year premium requirement is shown as the minimum required for that year. This is typically in excess of the actual mortality charges due to expenses incurred. The excess remains in the policy reserve to subsidize future premiums. 16 The policy used in this example has a premium structure until age 85, after which only 2 percent tax ($147) is payable. 11

15 Exempt Life Insurance: 8 Whole Life: level maximum premium at current dividend Here, the annual premium for life is $51,065: Age 81 Return 91 Return Cost $4,121,060 $6,737,791 Benefit $8,883, % $12,889, % Balance $4,762,050 profit $6,151,263 profit 9 Whole Life: level maximum premium for ten years at current dividend Where the annual premium for 10 years is $51,065, the cost/benefit analysis is as follows: Age 81 Return 91 Return Cost $1,767,764 $2,616,723 Benefit $4,406, % $6,273, % Balance $2,638,391 profit $3,656,279 profit If, after ten years, the premium deposits have ceased, the policy holder may resume the premium deposits, although the insurer may require evidence of insurability. Evidence of insurability is a declaration by the insured that there has not been a change in health. 10 Retirement Compensation Arrangement (RCA) A retirement compensation arrangement (RCA) is defined in subsection 248(1) of the Act as a plan or arrangement under which contributions (other than payments made to acquire an interest in a life insurance policy) are made by an employer or former employer of a taxpayer, or by a person with whom the employer or former employer does not deal at arm s length, to another person, or partnership, in connection with benefits that are to be or may be received or enjoyed by any person on, or after or in contemplation of any substantial change in the services rendered by the taxpayer, the retirement of the taxpayer or the loss of an office or employment of the taxpayer. We do not purport to provide an elaborate description of the RCA but illustrate what happens when an RCA is funded by an exempt life insurance policy. Contributions to an RCA are subject to a 50 percent refundable tax as defined in subsection 207.5(1) of the Act. Thus, if the annual funding requirement is $50,000 the total contribution will be $100,000. Half of this amount will be paid into the RCA trust and half will be withheld by the employer and remitted to the CRA as a 12

16 An Essential Tool in Tax and Estate Planning refundable tax. The advantage of using an exempt life insurance policy for funding an RCA is that it avoids the tax inefficiency that occurs when the RCA trust is funded with a non-tax sheltered investment, requiring the payment of a 50 percent refundable tax on earnings within the RCA trust. When an RCA is funded with exempt life insurance only the contributions are subject to tax and not any investment earnings within the policy. There are two advantages to funding an RCA with an exempt life insurance policy: 1) The 50 percent tax on the contributions received from the sponsor is refundable when benefits are paid. For each $2 of benefit, one dollar comes from the refundable tax account (RTA). 2) The exempt policy s accumulation within the RCA trust is fully taxsheltered. It is also fully accessible via leveraging during the insured s life. Table A illustrates an RCA using an exempt life insurance policy for a 58 year old non-smoking executive. The net level insurance portion (T-100) is owned by the executive s holding company (HOCO), and the balance (the investment portion) is owned by the RCA trust, to which the executive s employer makes an annual contribution. HOCO s portion of the total premium is what it would cost for the same insurance policy benefit on the open market. The balance of the annual premium is paid by the RCA trust on the investment portion of the policy. Because the employer company s contributions to the RCA Trust are subject to the 50 percent refundable tax, the employer must contribute double its share of the contributions. The contribution to the RCA trust is tax deductible to the employer company. Table A assumes a percent tax bracket (the current corporate rate in British Columbia). 13

17 Exempt Life Insurance: Cost/Benefit 34.12% Tax Bracket Supplementary Executive Retirement Plan Funded with Split Ownership RCA-Max. Investment Exempt Whole Life insurance 58 years old shareholder employee s HOCO owns basic insurance portion RCA owns balance in a participating policy at current dividend scale Financed by leveraging both the RCA contributions and the Retirement Benefits /Loan repaid on death at life expectancy age % tax bracket (6% cost of money 3.952% after tax) Total Annual Premium of $729,725 Total Death Benefit of $10 Million plus accumulated cash value Executive s HOCO RCA To fund $1,512,694 annual retirement benefits from age 65 to age 83 for 18 years ( total $27,228,492) Basic Life insurance $10,000,000 Need $1,089,140 deductible contribution to pay both investment portion of policy $544,570 to RCA Trust and refundable tax of $544,570 to Refundable Tax Annual Premium $185,155 Account. Benefit Benefit Death benefit at 83 $10,122,341 Death Benefit at 83 48,151,648 Value of accumulated cost of premiums (@ 21.8%) 17 $1,740,147 Less Executives Share (10,122,341) RCA s share 38,029,307 (7.2%) return Value of RTA on Death (25 X $544,570) 13,614,250 14

18 An Essential Tool in Tax and Estate Planning Total value $11,862,488 (6.64%) return Total Benefit 51,643,557 (9.17%) return Cost Cost $185,155 annual x % $7,964,060 After tax cost of contributions (1,089,140 X (100%-34.12%) = 717,525 x %) (30,866,438) Cost of leveraging benefits (1,512,694 / 2 =756,347 X 18 6%) (24,777,921) Profit $3,898,427 Total Cost (55,644,359) The value of the Capital Dividend Account has not been considered in these calculations. Cost on Death (Cost/Benefit Balance) (4,000,802) Upon death we have $38 million death benefit in the RCA Trust and $13.6 million in the RTA, a total of $51.6 million. On the cost side first we have the net cost of funding the deductible contributions of $1,089,140 a year for 25 years 3.9% is $30.8 million. Secondly the cost of 18 annual retirement payments from the RCA Trust of $756,347 is added to the same amount of withdrawals from the RTA which is depleted by assumed death at 83. At 6% non-deductible leveraging the cost is $24.7 million for 18 annual retirement income payments of $1,512,694. There is no cost of withdrawing the same $756,347 annually from the RTA. 17 The total cost of contributions and leveraging of benefits amounts to $55.6 million. If we compare this to the total cost of $55.6 it results in a $4.0 million loss. 17 Share value is reduced by the cost of premiums paid. Capital gains tax is saved on this reduction in share value. (185,155 X % cost of money) X 21.8% 15

19 Exempt Life Insurance: VIII. Uses of Permanent Insurance The value of the exempt policy is illustrated by the wide range of its uses. Not only can the policy be used for a specific objective, but also the flexibility of a contract can result in several advantages. For example, a fully funded policy can help supplement retirement income through leveraging. IX. Leveraged Insurance The leveraging of a life insurance policy is excluded from the definition of disposition of an interest in a policy and therefore allows for indirect access to the cash value of the policy without a tax consequence and without affecting the accumulated money within the policy. 18 Another significant beneficial use of a fully funded leveraged exempt policy is to fund estate obligations at death from the net death benefit proceeds after the loan has been repaid. X. Corporation-Owned Life Insurance The yield on most corporate assets will attract a tax liability. However, income earned by a private corporation that would not be subject to tax will also generally be tax free in the hands of that corporation s shareholders. The Capital Dividend Account The Capital Dividend Account (CDA) is the integration mechanism that allows a private corporation to realize the non-taxable portion of a capital gain and of lifeinsurance proceeds, remove it from the corporation on a tax-free basis and distribute those amounts tax-free to its resident Canadian shareholders. Subsection 89(1) of the Act includes, within the CDA, the proceeds of life insurance that a private corporation receives on the death of the individual who is insured under the policy, less the Adjusted Cost Basis (ACB) (subsection 148(9)) of the policy to the corporation immediately before death. The Adjusted Cost Basis is the cumulative premium deposits less the Net Cost of Pure Insurance 19, which increases rapidly at later ages. Where corporate assets will be the primary source of funds to meet an estate liquidity need, life insurance owned by the corporation can result in savings of about $461,988 of corporate funds per $1,000,000 of need for cash. To generate $1,000,000 in after-tax funds in the hands of an individual shareholder in the top income tax bracket, the private corporation would be required to declare 18 Monique Conrad, Life Insurance Can Provide Tax Benefits, (1998) 17 Lawyers Weekly The Net Cost of Pure Insurance is calculated in accordance with Reg. 308 (1) 16

20 An Essential Tool in Tax and Estate Planning a taxable dividend of approximately $1,461, On the other hand, with a full $1,000,000 CDA credit on a policy having a $1,000,000 death benefit and zero ACB, the $1,000,000 is received tax-free by both the corporation and the shareholder. The directors of a corporation may be reluctant to acquire a life insurance policy as an investment because of the belief that a greater rate of return can be achieved within the corporation than within the policy. This may well be true. However, the benefit of accessing these funds via leveraging the cash values inside the policy should not be overlooked. This planning strategy allows the policy to serve as collateral security for a bank loan, which can return to the policy owner all or part of the premium paid, meanwhile allowing the policy to accumulate tax-deferred income as well as provide tax-free proceeds upon death. If the borrowed funds are used to earn income, the interest on the loan should be tax-deductible. Furthermore, the amount deposited in the policy can produce a higher return than the after-tax cost of borrowing. The result can be little or no interference with corporate cash flow, the creation of liquidity when death of the insured occurs and, in the case of a private corporation, the credit to the Capital Dividend Account. Additional deposits within the exempt limits of a permanent policy provide further options to accumulate tax-sheltered wealth. A Universal Life policy is a flexible, market-sensitive life insurance product. Another option is to consider a participating policy, which has the following characteristics: i) a level premium payment; ii) guaranteed cash values; and iii) the right to receive dividends. In assessing the financial or investment viability of a participating policy the policy owner relies on the investment expertise of the insurer as it is the participating (par) account that will produce the investment results. XI. Advantages of Permanent Insurance This study demonstrates the unique and beneficial characteristics of permanent exempt life insurance. As a flexible tax-planning mechanism, exempt life insurance should not be overlooked in the assessment of a client s business, tax and estate liquidity needs. Whether a T-100 policy with no cash value, a Universal Life policy or a participating Whole Life policy with maximum deposits is used, this study concludes that investing in these financial contracts can yield substantial benefits for the policyholder. When cash is needed for business or investment, it is preferable to borrow using the policy cash value as collateral rather than to withdraw money from the policy. There are additional benefits available when a policy is held by a Canadian Controlled Private Corporation (CCPC): Tax-free capital dividends worth up to $461,988 per $1,000,000 of CDA credit (ss 89(1) of the Act) 20 Subject to projected changes in Federal & Provincial rules. Re: Taxation of Dividends. 17