TAX, RETIREMENT & ESTATE PLANNING SERVICES. A Guide to Leveraged Life Insurance WHAT YOU NEED TO KNOW BEFORE YOU LEVERAGE YOUR LIFE INSURANCE POLICY

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1 TAX, RETIREMENT & ESTATE PLANNING SERVICES A Guide to Leveraged Life Insurance WHAT YOU NEED TO KNOW BEFORE YOU LEVERAGE YOUR LIFE INSURANCE POLICY

2 This guide provides information on leveraged life insurance. We hope it will help you understand and assess the benefits and risks of a particular leveraged life insurance strategy and determine whether that strategy is right for you. The information in this guide will be useful in considering most leveraged life insurance strategies, including: The Insured Retirement Program (Corporate and Personal) Immediate Finance Arrangement The guide is in an easy-to-use, question and answer format. We recommend that you read all the questions and answers to make sure you fully understand the entire range of issues associated with leveraged life insurance. 2

3 1. What is leverage and how do people use it? Leverage is, quite simply, taking out a loan. The loan can be secured or unsecured. The loan arrangements discussed in this guide are secured loans often referred to as collateral loans. A loan is secured when a specific asset is assigned as collateral security for the loan. The lender can, if necessary, seize the property provided as collateral and liquidate it to repay the debt. It is often easier (and cheaper) to obtain a secured loan. A real estate mortgage is a good example of a secured loan. The amount a lender will loan to a particular borrower usually depends on a number of factors, including the borrower s credit rating (based on credit history), current and future income levels, net worth, etc. If an asset is assigned as collateral security, the lender will also evaluate the nature of that asset (value, liquidity, etc.). Based on these factors, lenders will determine the amount they are willing to advance relative to the value of a particular asset. This is referred to as the margin. For example, residential real estate is often leveraged based on a 90% margin, meaning that if a house is worth $100,000, a bank will loan up to $90,000. At a 75% margin, a bank will loan $75,000. A higher leverage margin may mean higher interest costs because the lender is assuming a greater risk. The purpose of leveraging is to provide funds for the borrower to make a purchase or pay expenses. Money for an expenditure may be borrowed for a variety of reasons: the borrower may not have sufficient cash (capital) to pay for the expenditure (as is the case with most home purchases); the borrower may have the funds to pay for the expenditure, but may not wish to use them for this expenditure (capital preservation); or, in the case of an investment purchase, the borrower may have some funds, but may want to buy more of the investment to improve the return on capital. It s important to be aware that leveraging for investment purposes can be a double-edged sword. If the expected investment returns don t materialize, the return with leveraging can actually be worse than without it. And in some cases, leveraging can create losses. (See Appendix A) 3

4 2. How do I use my life insurance policy to obtain a collateral loan? Like any other asset, a life insurance policy can be pledged as collateral security for a loan. In some cases, a lender may require that a life insurance policy be purchased on the life of the borrower and pledged as collateral for a loan. The life insurance policy would then be used to repay the loan if the borrower dies. In this case, the life insurance policy, in conjunction with other assets and/or guarantees, provides the security for the loan. A guarantee is an agreement in which one person assumes responsibility for assuring payment or fulfillment of another s debts or obligations. Certain types of policies allow cash value to grow inside the policy. This growth occurs when the owner makes deposits into the policy in excess of what is needed to cover the insurance charges. The growth will accumulate within an exempt life insurance policy on a tax-deferred basis, within limits set by the Income Tax Act (the Act ). If a life insurance policy has cash value, the policy alone can provide the collateral needed to obtain a loan. Many lenders will provide collateral loans secured by a life insurance policy at margins of 75% (or sometimes as high as 90%) of the policy s cash value. In certain situations, a combination of an insurance policy and other assets serve as collateral for the loan. The borrower may use the loan proceeds to invest in a business or property, purchase other assets or pay living expenses. In these cases, the interest on the loan and a portion of the insurance premiums may be deductible for tax purposes. The tax savings can reduce the cost of borrowing. When the borrower dies, the life insurance policy s death benefit will repay the collateral loan. Any remaining death benefit will be paid to the beneficiary designated within the insurance policy. 4

5 3. How do leveraged life insurance strategies work? As described in the answers to questions 1 and 2, the basic concept of leveraging the cash value of a life insurance policy is relatively simple. The complexity lies in the many different ways leveraged life insurance strategies are structured and the assumptions that underlie those structures. To determine whether a particular leveraged life insurance strategy will be suitable for you, you first need to fully understand how that strategy works. The italic notes in this section provide information to help you understand a particular leveraged life insurance strategy presentation from Manulife Financial (referred to below as the concept presentation ) that may have been prepared for you. WHO IS THE POLICY OWNER? WHO IS THE BORROWER? WHO IS THE LIFE INSURED? A life insurance policy may be owned by an individual or by a corporation. The life insured may be the policy owner or a third party. For corporateowned insurance, the life insured is always a third party, commonly a shareholder or employee of the corporation. Refer to your Manulife product illustration to determine who the insured is. The Manulife concept presentation shows who the borrower is. Either an individual or a corporation can pledge a life insurance policy as collateral for a loan. Usually the policy owner and the borrower are the same person/corporation, but this is not always the case. It is important to understand who the owner is because the owner must pay the premiums. The borrower, on the other hand, is the one who receives the loan. In addition, if the funds to pay the premiums or the borrowed funds must flow between different parties, you will want to plan carefully to make sure this arrangement is structured in a tax-effective manner. 5

6 WHAT TYPE OF LOAN IS IT? A collateral loan may be structured as a line of credit, a term loan or a demand loan. A line of credit is an agreement by a lender to lend up to a specified amount (the line of credit limit) to a borrower. It allows amounts to be borrowed, repaid, and reborrowed at any time, provided the loan balance does not exceed the line of credit limit. Multiple advances and repayments may occur on this type of loan. A term loan is typically a loan where the lender advances a specific amount to the borrower on a specific date. With a term loan, the interest and payment terms may vary, but the outstanding loan balance is due to be repaid at the end of a defined time period (i.e. the loan term). The specific terms and structure of your loan must be negotiated with the lender and may be different than the terms assumed in your Manulife concept presentation. A demand loan does not have a specific term to maturity. Instead, the lender can demand payment at any time, even if the loan is in good standing. A line of credit is usually structured as a demand loan. With all of these types of loans, the specific loan terms can vary widely (discussed further below). WHEN ARE THE LOAN FUNDS ADVANCED? The larger the deposits and the longer the cash value is allowed to grow before leveraging it, the larger the available loan advances will be. Loan advances may be structured as a steady stream of equal or variable payments or as one lump sum. Your Manulife concept presentation shows the assumed stream of loan advances year by year. Regardless of the timing of the advances, the loan balance cannot exceed the lender s specified margin relative to the cash surrender value of the policy, unless additional collateral is provided. HOW MUCH OF MY POLICY S CASH SURRENDER VALUE CAN I LEVERAGE? Banks will lend anywhere from 50% to 90% of the policy s cash surrender value. Factors such as the type of policy and how the funds within the policy are invested will affect the lending margin. For example, if policy funds are invested in equity accounts, the margin is typically lower (50%) because of the volatility of the returns on these accounts. If the policy funds are invested in guaranteed investment accounts, the margin may be higher (75%-90%) because the returns are guaranteed. Advances shown on your Manulife concept presentation are limited so the assumed margin is never exceeded before the insured s assumed life expectancy. Loan advances may begin almost immediately or they may begin many years down the road. If the policy s cash value is leveraged immediately, the amount that can be borrowed is impacted by lower early cash values (cash value growth takes time). Larger loan amounts may be available if additional collateral is provided. 6

7 DO I NEED TO PROVIDE ADDITIONAL COLLATERAL? IF SO, WHAT TYPE OF COLLATERAL AND WHAT IS THE MARGIN ON THAT COLLATERAL? To obtain a larger loan, some leveraged life insurance strategies, particularly those where loan advances begin immediately, assume that additional collateral will be provided. The lender will determine the lending margin that will apply to the particular collateral asset. The maximum loan available at any point in time will be based on the combination of the policy s cash surrender value (at the lending margin for the cash surrender value) and the additional collateral provided (at the lending margin for the particular asset). Additional collateral required (if any) is shown in a separate column on your Manulife concept presentation. The type of collateral and the assumed margin is also shown. For example, Manulife Bank will normally accept a GIC leveraged at a 90% margin. DO I PAY INTEREST ON THE LOAN DIRECTLY OR IS IT ADDED TO THE LOAN BALANCE? Depending on the particular leveraged life insurance strategy, interest may be paid monthly, annually or it may be added to the loan balance (often referred to as capitalizing ). When interest is capitalized, compound interest (interest on interest) will arise. This can be an issue with respect to interest deductibility (discussed below). To ensure full interest deductibility, many leveraged life insurance strategies assume that the interest is paid annually out-of-pocket, but each year a new loan is advanced for the same amount as the interest cost. This has the same economic effect as if the interest were capitalized, but for tax purposes, the loan balance remains only principal and no compound interest arises. On your Manulife concept presentation, if the growth in the loan balance is more than the amount of the annual advances, the additional amount represents advances to cover the aftertax interest costs of the loan. 7

8 If interest deductibility is assumed, the presentation may show the tax savings being applied to reduce the loan balance or to increase cash flow. The collateral insurance deduction assumed (if any) is shown in a separate column on your concept presentation. ARE THE INTEREST COSTS ASSUMED TO BE DEDUCTIBLE? IS IT ASSUMED THAT THE COLLATERAL INSURANCE DEDUCTION WILL BE CLAIMED? Leveraged life insurance strategies may or may not assume that the interest on the loan is deductible for income tax purposes. If the strategy assumes that interest is deductible, often the tax savings resulting from the deduction are applied to the loan balance or shown as a reduction to the interest payments. Similarly, if a policy is assigned as collateral for a loan, a deduction may be available for all or a portion of the premiums paid for that policy, referred to as the "collateral insurance deduction. As with loan interest, leveraged life insurance strategies may assume that premiums are deductible and they may apply the tax savings resulting from the deduction to reduce the loan balance or cash outflows. It is important to understand whether these assumptions are valid in your particular situation because they can have a very significant impact on the benefits presented to you. (See sections 5 and 6 for a discussion of the economic and technical tax issues associated with interest deductibility and the collateral insurance deduction assumptions.) ARE THE LOAN ADVANCES EQUAL TO THE INSURANCE DEPOSITS AND, IF SO, IS THIS FREE INSURANCE? There is no such thing as free insurance. Some leveraged life insurance strategies are structured so the loan advances equal the deposits each year. Although these arrangements may be cash neutral (i.e. cash inflows equal outflows), the insurance is not free. The insurance charges still come out of the policy values and interest is charged on the loan (although it may be capitalized and paid at death). In addition, other collateral may need to be provided to secure the loans, which encumbers these assets. It is important to consider whether the insurance coverage (net of the loan balance) obtained with the particular leveraged life insurance strategy meets your needs. 8

9 4. What are the economic and practical issues I may encounter if I leverage my policy? WHAT ARE THE TERMS OF THE LOAN? The terms of a loan will vary greatly, depending on the lender s practices, the characteristics of the borrower, the collateral provided and the timing of the advances. The interest terms, in particular, can significantly impact the cash flows. Interest may be payable annually or there may be an opportunity to capitalize it. The interest rate may be locked in for a period or it may be a floating rate tied to a benchmark, such as prime. The actual interest rate will depend on rates available at the time the loan is made. Additional collateral or guarantees may be required, depending on the amount of the desired loan advances. In addition, bank fees and professional fees may be incurred to set up the collateral loan. WHEN WILL THE LOAN BE REPAID? In general, loans secured by the life insurance policy s cash value are intended to remain outstanding until the life insured s death. With this structure, the loan will be repaid at the time of death with the life insurance proceeds. A collateral loan may be repaid at any time, subject to any applicable early repayment penalties. If the policy s cash value is withdrawn to fund the repayment, it may result in a taxable policy gain. If the loan is a term loan, the loan must be repaid or renegotiated when the term ends. In some cases, the lender may provide a guarantee to renew the loan if the life insured is still alive at the end of the term. If renewal is not guaranteed, the borrower needs to consider how the loan will be repaid or refinanced at term-end. If any of the terms of a collateral loan agreement are breached or if the loan agreement allows the lender to demand payment before death, the lender may require repayment of the loan (in whole or in part) before the life insured s death. If the borrower cannot repay the loan or negotiate an alternative with the lender (such as providing additional or alternative collateral), the lender may force the surrender of the life insurance policy so the cash value can be used to repay the loan. A surrender of the policy in these circumstances has severe consequences to the policy owner. It may trigger a taxable policy gain. The policy proceeds are paid to the lender, the policy owner is left to pay any tax owing from the gain and the insurance coverage is terminated. This shows how critical it is that you understand when and under what circumstances the lender is entitled to demand payment of the loan. 9

10 HOW DO INTEREST AND COLLATERAL INSURANCE DEDUCTIONS IMPACT THE LEVERAGED STRATEGY? Many leveraged life insurance strategies assume that the interest paid on the loan is deductible for tax purposes and that the collateral insurance deduction is available. If these deductions are available, the tax savings generated by the deductions decrease the cost of borrowing. For example, if the interest rate on the loan is 8%, but the borrower can deduct the interest from his taxable income and save 3% in taxes, the after-tax cost of borrowing is 5%. If the collateral insurance deduction saves the borrower another 1% in taxes, the after-tax cost of borrowing is further reduced to 4%. As a result, these deductions can significantly increase the borrower s net investment return. However, if the deductions are not available or if the value of the deductions is overstated, the economic viability of the strategy can be compromised. (See Appendix A for an illustration of how tax savings can impact investment returns.) This means that you need to understand and be comfortable with the assumptions made regarding these deductions in the leveraged strategy that you are considering. HOW MUCH INCOME DO I NEED TO USE THE INTEREST AND COLLATERAL INSURANCE DEDUCTIONS? A tax deduction has value only if the taxpayer s taxable income exceeds the deduction. This means that, if the loan remains outstanding during a borrower s entire life then, in every year during that life, the borrower s taxable income must exceed the total of the interest expense and the collateral insurance deduction. Most leveraged life insurance strategies assume the loan grows each year, which results in increasing interest costs. Consequently, the borrower s taxable income must also increase to use the growing deductions. The size of the loan in any given year will be affected by the timing and size of the advances and whether interest is being paid or capitalized. Leveraged life insurance strategies where loan advances begin immediately have a much longer time period where large interest costs may be incurred than strategies that involve leveraging at a later date. Many of Manulife s concept presentations show the income required to use deductions. 10

11 HOW MUCH TAX WILL I SAVE BY CLAIMING THE INTEREST AND COLLATERAL INSURANCE DEDUCTIONS? This is essentially a question of what tax rate should be applied to the deductions to determine the value of the tax savings. Typically, the top marginal tax rate of the borrower is used, but this may have to be adjusted downward if the deductions will reduce income to a lower tax bracket. In corporate situations, you need to consider whether the deductions will be applied to reduce active business income or passive investment income. If the deductions are applied to passive income, you must also consider the impact on refundable corporate taxes. On Manulife s concept presentations the tax savings from deductions either reduce the outstanding loan balance or increase the annual cash flow. As an example, if your tax rate is 40% and you have $1,000 of taxable income, the tax payable will be $400. If you have a $600 deduction, your taxable income is reduced to $400 and your tax payable is $160. Therefore, you will realize a tax savings of $240 on a $600 deduction. HOW DOES MY INSURANCE POLICY S PERFORMANCE AFFECT MY LEVERAGED LIFE INSURANCE STRATEGY? When the cash value of a life insurance policy is leveraged, the cash surrender value must always grow at least as fast as the loan balance to maintain the loan to cash surrender value margin that the lender requires. Whole life policies, such as Performax Gold, are designed to provide positive, stable cash values. This makes Performax Gold particularly suitable when the loan margins are high and the loan is expected to be outstanding for a long period of time. Performax Gold s stability reduces the risk of exceeding the loan margins. The cash value of the policy is impacted by the amount and timing of deposits, the insurance and other policy charges, and the return on the accumulated value within the policy (the policy rate ). The policy rate will vary depending on the type of policy, the policy s guarantees and, if applicable, the investment accounts the policy owner has chosen within the policy and how they ve performed. If the policy rate is higher or lower than expected, it will have a corresponding effect on the amount and/or timing of the loan advances. 11

12 Concept presentations usually show interest and policy rates as fixed rates for life. Unless these rates are guaranteed for life, actual results will be different from the presentation. WHAT HAPPENS IF MY LOAN BALANCE EXCEEDS THE CASH SURRENDER VALUE MARGIN? The loan balance is impacted by the amount of the loan advances and repayments, the loan interest rate (if interest is being capitalized or additional advances are taken to cover interest costs) and any tax savings applied to the loan balance. Therefore, the lender s required margin may be exceeded if advances are larger or earlier than expected, if loan interest rates increase, if anticipated tax savings are not realized and consequently cannot be applied as loan repayments, or if the policy rate is lower than expected. The longer a loan remains outstanding, the greater the risk that interest rates, tax savings, or policy rates will vary from projections made in concept presentations. If the loan margin is exceeded, the borrower may be required to make unexpected interest or principal payments on the loan, make additional deposits into the insurance policy or provide additional collateral. IF I USE MY BORROWED FUNDS TO INVEST, HOW DO THE RETURNS ON MY INVESTMENT IMPACT MY LEVERAGED LIFE INSURANCE STRATEGY? The income from your investment can create taxable income and you may be able to claim the interest and collateral insurance deductions against this income. If you have no other income, the income from the investment must exceed these deductions for you to be able to fully realize the tax benefits. Your investment returns will also impact the growth in the investment value. If you ever want to repay the loan using proceeds generated by selling the investment, the investment must have a value at least equal to the loan balance or you will also need to use other assets or the life insurance policy s cash value to repay the loan. 12

13 WHAT HAPPENS TO MY LEVERAGED LIFE INSURANCE STRATEGY IF I MOVE TO ANOTHER COUNTRY? It can be difficult to enforce repayment of a loan by a non-resident. Consequently, a Canadian lender, depending on its lending practices, may not loan to non-residents or may do so only at a lower margin. If you leverage your policy and then leave Canada, you may be required to provide additional collateral or repay all or a portion of your loan. If you leave Canada and later decide to leverage your policy, you may have to obtain the loan from a lender in your new country of residence. You also need to consider the tax treatment your leveraged life insurance strategy will receive in a foreign jurisdiction. Depending on your life insurance policy, the accumulation of cash value inside the policy may be taxable in your new country of residence. Similarly, you will want to consider the tax treatment of a collateral loan secured by a life insurance policy in the new jurisdiction. In some countries, such a loan may give rise to taxable income. WHAT HAPPENS IF I WANT TO COLLAPSE MY LEVERAGED LIFE INSURANCE STRATEGY? A number of factors may prompt you to re-evaluate your leveraged life insurance strategy and decide to collapse the whole arrangement. These factors include changes to your circumstances or to investment or policy returns, loan interest rate increases or failure to realize the expected tax benefits. When you have made this decision, the first step will be to repay the loan. If you have invested the borrowed funds in an asset that can be liquidated and the asset value has grown to equal or exceed the loan balance, you can sell the asset and use the proceeds to repay the loan. Depending upon the nature of the asset, there may also be tax consequences on the liquidation of the asset. The cash value life insurance policy can then either be left in place or surrendered. If it is surrendered, you will recover the cash surrender value of the policy. However, to the extent that the cash surrender value exceeds the adjusted cost basis of the policy, a policy gain will be triggered for tax purposes. If the leveraged funds are invested in an asset that cannot be liquidated and no other funds are available to repay the loan, then it may be necessary to surrender the life insurance policy to obtain the funds to repay the loan. (Refer also to the question above When will the loan be repaid? ) The adjusted cost basis (ACB) of a life insurance policy is calculated by using a complex formula set out in the Act. Among other things, the ACB is increased by the cumulative deposits to the policy and decreased by the cumulative Net Cost of Pure Insurance or NCPI (discussed on page 18). 13

14 5. What tax issues should I be aware of before I enter into a leveraged life insurance arrangement? A. INTEREST DEDUCTIBILITY WHAT ARE THE REQUIREMENTS FOR INTEREST ON MY LOAN TO BE DEDUCTIBLE FOR INCOME TAX PURPOSES? The Act provides the framework for determining the deductibility of interest. The key requirements are: n n n n Paid or payable: Interest must be paid or payable in respect of the taxation year. Legal obligation: Interest must be paid as a result of a legal obligation. Purpose test: The borrowed funds must be used for an income-earning purpose - i.e. to earn income from a business or property or to acquire property for the purpose of earning business or property income. Linking test: The borrower must be able to demonstrate that the borrowed money is used for an income-earning purpose. A paper trail must exist that demonstrates the flow of the borrowed money to the income-earning purpose. This is often referred to as linking the borrowed funds to the eligible use. If loan proceeds flow from the bank to a personal or other ineligible use, this test will not be met. All of these requirements must be met to qualify for an interest deduction. In addition, interest is subject to a general reasonableness limitation that restricts the interest deduction to a reasonable amount. HOW IS THE TIMING OF MY DEDUCTION AFFECTED IF I NORMALLY REPORT MY INCOME ON A CASH BASIS? If you regularly report your income based on when you actually receive and disburse funds, you may deduct interest only in the year in which the interest is paid. As a result, if you borrow against the cash value of a life insurance policy and the interest on that loan is capitalized rather than paid, the interest deduction will not be available until the loan is repaid with the insurance policy's death benefit proceeds. If you wish to deduct the interest expense before that time, the loan must be structured so the interest is actually paid annually. Taxpayers who report their income using the accrual method (i.e. report income and expenses in the periods to which they relate) may deduct interest in the year in which it is payable. (Please note: The following discussion is based on the Income Tax Act ( the Act ), case law and Canada Revenue Agency s (CRA) assessing practices at the time of writing.) 14

15 IS THE INTEREST ON MY COLLATERAL LOAN PAID AS A RESULT OF A LEGAL OBLIGATION? Lending arrangements with an institution are typically documented by a written agreement that establishes the legal obligation to pay the interest. IF I USE BORROWED FUNDS TO PAY MY PERSONAL EXPENSES AFTER I RETIRE OR TO ACQUIRE A VACATION PROPERTY, WILL THE INTEREST BE DEDUCTIBLE? To receive an income tax deduction for interest, the borrowed funds must be used for, or used to acquire property for, the purpose of earning income from a business or property. Interest on borrowed money used to fund personal expenditures, such as providing retirement income or acquiring a vacation property, does not meet this requirement and is therefore not deductible. A common planning strategy is to use cash or liquidate investments to fund personal expenditures and then use borrowed funds to invest or repurchase investments. IF I USE BORROWED FUNDS TO ACQUIRE INVESTMENTS OR CONTRIBUTE CAPITAL TO A CORPORATION, WILL THE INTEREST BE DEDUCTIBLE? The purpose test outlined by the Act requires that the property acquired produces income. Income refers to things like interest, rents, royalties, business income, or trading gains. It does not include capital gains. This means that if funds are borrowed to invest in mutual funds that will generate only capital gains, the interest on the borrowed funds will not be deductible. If the investment you purchase will generate at least some income, the purpose test should be met. An exception to this general rule occurs when funds are contributed to a closely-held corporation by the shareholder(s). Generally, a deduction for interest would be allowed if the borrowed money were used by a shareholder (or shareholders in proportion to their shareholdings) to make an interest-free loan (or a capital contribution) to a closely-held corporation. This exception will apply provided the loan has an effect on the corporation s income-earning capacity, thereby increasing the potential dividends to be received. IF I USE BORROWED FUNDS TO MAKE DEPOSITS INTO A LIFE INSURANCE POLICY, WILL THE LOAN INTEREST BE DEDUCTIBLE? Specific wording in the Act prohibits the deduction of interest on borrowed money used to acquire a life insurance policy (including an annuity, but excluding segregated funds). This means that if the borrowed money is deposited into a life insurance policy, the interest is not deductible. You can, however, sell an investment portfolio to make a deposit into the life insurance policy and then repurchase the investments with borrowed funds secured by the life insurance policy. Since the borrowed funds have been used to acquire property that earns income, the Act s linking and 15

16 purpose tests are met and the interest may now be deductible. Where these steps are taken, the transactions cannot simply be reflected on paper by journal entry only - actual sales and purchases must occur. Depending on the nature of the investments, tax consequences may arise from these transactions. IF I USE BORROWED FUNDS TO ACQUIRE AN ANNUITY, WILL THE LOAN INTEREST BE DEDUCTIBLE? As noted in the previous question, interest on borrowed money used to acquire a life insurance policy, including an annuity, is not generally deductible. An exception to this rule allows an interest deduction on borrowed money used to acquire a non-prescribed annuity. In this case, the deduction is limited to the annuity income included in the taxpayer s taxable income for the year. IF MY CORPORATION OWNS A LIFE INSURANCE POLICY AND LEVERAGES THE POLICY TO PAY A DIVIDEND, WILL THE PURPOSE TEST BE MET? Generally, interest on borrowed funds used to pay a dividend from a corporation will be deductible, regardless of what is pledged as security, provided the dividend does not exceed the corporation s undistributed profits. HOW DO I KNOW IF THE INTEREST ON MY LOAN EXCEEDS A REASONABLE AMOUNT? In determining whether an interest rate is reasonable, you need to consider prevailing market rates for debts with similar terms and credit risks. An interest rate established in a market of lenders and borrowers, acting at arm s length from each other, is generally a reasonable rate. Any interest in excess of a reasonable amount will not be deductible. B. COMPOUND INTEREST WHAT IS COMPOUND INTEREST? Simple interest is interest paid on the original amount borrowed (the principal). As noted earlier, compound interest arises when simple interest is added to the loan balance (i.e. capitalized), rather than being paid. The interest arising on interest is referred to as compound interest. WHAT REQUIREMENTS MUST BE MET TO DEDUCT COMPOUND INTEREST FOR INCOME TAX PURPOSES? Compound interest is really interest on money borrowed to pay interest, so it is not deductible under the provisions discussed above. Compound interest does not meet the purpose test (paying interest is not an income-producing purpose). However, a separate provision in the Act does permit a deduction for compound interest if it is paid pursuant to a legal obligation to pay interest, and if the simple interest to which it relates is deductible. Note that the wording here is paid, not paid or payable, as is the case for simple interest. IF I CAPITALIZE THE INTEREST ON A LOAN SECURED BY MY LIFE INSURANCE POLICY, IS THE COMPOUND INTEREST DEDUCTIBLE FOR INCOME TAX PURPOSES? Compound interest that arises from capitalizing the interest on a loan secured by a life insurance policy should be deductible if the simple interest to which it relates is deductible and if it results from a legal obligation to pay interest. The crucial question, however, is when will it be deductible? The answer is - when it is paid. As noted earlier, loans secured by life insurance policies are frequently intended to remain outstanding until the life insured s death, when the loan will be repaid with the death benefit. If the interest is capitalized, the compound interest is not paid until the time of death and no interest deduction for the compound interest will be available until death. One way to avoid this result is to actually pay the interest on the loan annually. Then each year, a new 16

17 loan can be advanced for the same amount as the interest cost. [Note that to ensure deductibility of the interest on these new loans, the loan proceeds must be used to produce income.] This approach has the same economic effect as if the interest were capitalized, but for tax purposes, the loan balance remains only principal and no compound interest arises. C. COLLATERAL INSURANCE DEDUCTION IF I LEVERAGE MY LIFE INSURANCE POLICY, CAN I DEDUCT THE LIFE INSURANCE PREMIUMS FOR TAX PURPOSES? Generally, premiums paid under a life insurance policy are not an allowable deduction for income tax purposes. There is, however, a specific provision in the Act that permits a deduction for life insurance premiums if the assignment of the life insurance policy is required by a lender under the terms of a loan (the collateral insurance deduction ). The deduction is not available if the loan is a policy loan. The lender must be a restricted financial institution, as defined under the Act, and the interest payable on the money borrowed must be deductible from the borrower s income. Note that to claim this deduction, the owner of the policy must also be the borrower. This means that if a policy owned by one person/corporation is pledged as collateral for a loan advanced to a different person/corporation, a collateral insurance deduction will not be available. HOW MUCH OF THE LIFE INSURANCE PREMIUMS CAN I DEDUCT? For any taxation year, the amount deductible with respect to the premiums paid for a policy used as collateral for a loan may not exceed the lesser of the premiums payable and the Net Cost of Pure Insurance (NCPI) for the policy for that year. The intent of the NCPI is to represent the pure mortality costs under the policy. It is based on mortality factors obtained from the Canadian Institute of Actuaries (CIA) and the net amount at risk under the policy. The NCPI increases each year after a policy is issued, primarily because mortality factors increase as the life insured ages. The amount deductible must also relate to the amount owing on the loan for which the life insurance policy has been assigned as collateral. For example, if the assigned policy has coverage of $1,000,000 and the average borrowing under the loan for the year is $600,000, the amount deductible would be limited to 60 percent of the lesser of the premiums payable and the NCPI for the policy for the year. 17

18 CAN I CLAIM THE COLLATERAL INSURANCE DEDUCTION IN YEARS WHEN I DON T MAKE DEPOSITS INTO THE POLICY? The answer to this question depends on the type of policy securing the loan. If the policy has a specified premium under the contract (as is commonly found in participating policies), the specified premiums could be considered premiums payable for the purposes of this deduction, even if they are paid out of internal policy values. Consequently, a deduction can be claimed. In contrast, according to the CRA, for a universal life contract, premiums payable does not include cost of insurance charges paid out of policy values. Only deposits to the policy are considered premiums. Therefore, if no deposits are made into a universal life policy in the year, a collateral insurance deduction is not available. D. GENERAL ANTI-AVOIDANCE RULE (GAAR) When considering any leveraging strategy, you should be aware of the possible application of the General Anti-Avoidance Rules (GAAR) contained in the Act. The intent of the GAAR provisions is to distinguish between legitimate tax planning and abusive tax avoidance and to establish a reasonable balance between the protection of the tax base and taxpayers need for certainty in planning their affairs. CRA may choose to apply GAAR in certain situations, it should not interfere with the well-established principle of law that a taxpayer is entitled to structure his or her affairs in a tax-efficient manner. GAAR may apply to any planning strategy, whether or not that strategy involves life insurance and/or leveraging. However, in leveraged life insurance strategies involving collateral loans, one particular risk is that GAAR might be used to recharacterize a collateral loan as a policy loan. This risk is mitigated if the loan is subject to separate underwriting and issued by a lender other than the insurer. E. FUTURE CHANGES TO THE INCOME TAX ACT IF I MEET ALL THE REQUIREMENTS IN THE ACT, WILL THE TAX BENEFITS SHOWN IN MY LEVERAGED LIFE INSURANCE STRATEGY PRESENTATION CONTINUE INTO THE FUTURE? The tax benefits of any strategy are dependent on tax legislation. There is always a risk that tax legislation may be changed and some of the tax benefits anticipated when you considered your strategy will no longer be available. Historically, legislative changes are not implemented retroactively, but future deductions (and the related benefits) may be affected. It s important to consider the impact of the loss of tax benefits in relation to any leveraged life insurance strategy. GAAR may apply to any transaction that attempts to avoid taxes. This may be a single transaction or a series of transactions that result in a tax benefit. While 18

19 6. Is leveraged life insurance right for me? DO YOU HAVE A PERMANENT INSURANCE NEED? DOES THE INSURANCE POLICY MEET YOUR INSURANCE NEEDS? Most leveraged life insurance strategies are intended to provide permanent life insurance protection, as well as access to capital during the individual s life. It is important to ensure that the insurance policy on which your leveraged strategy is based meets your insurance needs, even if you decide not to leverage the policy or if you decide to unwind the leveraged strategy at a later date. DO YOU HAVE SIGNIFICANT ASSETS AND PAY TAX AT THE HIGHEST RATE? Leveraged life insurance strategies are best suited to situations where the borrower has significant assets and cash flows that exceed their requirements for lifestyle or business operations. If interest rates should rise or the investment performs poorly, it may be necessary to use other cash assets to reduce or secure the debt. Also, to realize the maximum benefits of the interest and collateral insurance deductions, it is important that the borrower has significant taxable income and is paying tax at the highest rate. ARE YOU A SOPHISTICATED INVESTOR WHO IS COMFORTABLE TAKING ON FINANCIAL RISK AND WILLING TO SEEK ADVICE FROM A PROFESSIONAL ADVISOR? Leveraged strategies, including leveraged life insurance strategies, are inherently more risky than non-leveraged strategies. Returns can be amplified, but so too can losses. Before entering into any leveraged strategy, it is imperative for you to seek the advice of a professional advisor to assess the suitability of a specific arrangement to your particular circumstances. Many of the benefits of leveraged strategies are not guaranteed. Your professional advisor can help you assess the risks and the likelihood of realizing the illustrated benefits. 19

20 ARE YOU PLANNING FOR THE LONG TERM? Leveraged life insurance strategies are usually intended to be in place for life and can be difficult to unwind. It is important that you are comfortable with long-term planning and investment strategies. DO YOU HAVE A NEED FOR CAPITAL TO INVEST OR DO YOU HAVE LIQUID INVESTMENTS? Alternatively, if you have liquid investments, you may be able to liquidate the investments, use the proceeds to fund a life insurance policy and/or an annuity, use the policy as collateral for a loan, and then use the borrowed funds to repurchase the investment. Depending on the nature of the asset, tax consequences may arise from the liquidation of investments to carry out these steps. The key to making most leveraged life insurance strategies work is ensuring the loan interest is deductible. The starting point for deductibility is ensuring the borrowed funds are used for business or investment purposes. If you have a need for capital, the cash value of a life insurance policy can provide the collateral to obtain a loan. Conclusion Leveraged strategies, whether or not they involve life insurance, provide an opportunity to improve returns, but they also present higher risks. For people or corporations who own or purchase cash value life insurance, leveraging creates an opportunity to access the tax-sheltered growth inside the policy in a tax-efficient manner or to improve cash flows. If you or your corporation can answer yes to the questions in Section 6, then you should consider a leveraged life insurance strategy. 20

21 Appendix A The Case of Mr. Leverage LEVERAGE THE DOUBLE-EDGED SWORD Assume Mr. Leverage has $2,000 of cash to invest. He could invest just the $2,000 or he could invest $8,000 using his $2,000 cash plus a $6,000 loan from a bank. (The asset may be assigned as collateral to the bank and, in this case, the margin would be 75%. This is also sometimes referred to as a 3:1 loan for every $1 Mr. Leverage puts into the investment, the bank loans him $3.) Assuming the loan has a 6% interest rate, let s look at what happens to his returns if his investment generates a +8% return, and a 8% return. +8% Return -8% Return Cash Only Cash + Loan Cash Only Cash Loan Capital (A) $2,000 $2,000 $2,000 $2,000 Borrowed funds 0 6, ,000 Total invested $2,000 $8,000 $2,000 $8,000 Return in the first year (160) (640) Cost of borrowing (6%) 0 (360) 0 (360) Net return (B) $160 $280 ($160) ($1000) Rate of return (B/A) 8% 14% -8% -50% By using borrowed money in addition to his own, Mr. Leverage amplifies his returns. n n If his investment works out well and has a positive return, he can improve his returns in this case, going from an 8% return to a 14% return! If his investment returns are negative, this too is amplified in this case, going from a 8% return to a 50% return! 21

22 THE EFFECT OF RETURN AND LOAN INTEREST RATE FLUCTUATIONS Now consider what happens if, instead of an 8% return, Mr. Leverage achieves only a 5% return. And then what happens if his loan interest rate jumps to 7%? Cash Only Cash & 6% Loan Cash & 7% Loan Capital (A) $2,000 $2,000 $2,000 Borrowed funds 0 6,000 6,000 Total invested $2,000 $8,000 $8,000 Return in the first year (5%) Cost of borrowing 0 (360) (420 ) Net return (B) $100 $40 ($20) Rate of return (B/A) 5% 2% -1% As much as leverage can improve return on capital, if the returns and loan interest rates are not guaranteed, there is also potential for not only decreased returns, but also real losses even when the investment itself has positive returns. THE EFFECT OF TAX SAVINGS FROM DEDUCTIONS Let s reconsider the original example (+8% return on investment, 6% loan rate), factoring in tax on the income and the tax savings from deductions. Assume a tax rate of 50%. No Loan Loan with Deductions Loan without Deductions Capital (A) $2,000 $2,000 $2,000 Borrowed funds 0 6,000 6,000 Total invested $2,000 $8,000 $8,000 Return in the first year (8%) Tax on income (50%) (80) (320) (320) Cost of borrowing (6%) 0 (360) (360) Tax savings from deductions (50%) Net return (B) $80 $140 ($40) Rate of return (B/A) 4% 7% -2% If these deductions are available, Mr. Leverage has improved his return to 7% on capital an increase of 3%! However, if the deductions are not available, perhaps because the arrangement has not been structured properly, the impact can turn a positive return into a negative one. In this case, a 4% return has changed into a 2% return. 22

23 Manulife, Manulife Financial, the Manulife Financial For Your Future logo, the Block Design, the Four Cubes Design, and strong reliable trustworthy forward-thinking are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license. MK1847E 05\2014