instant insurance risk tolerance and tax needs are carefully considered.

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1 instant insurance by david wm. brown, a partner at Al G. Brown & Associates in Toronto & george weinberger, a former tax partner with KPMG. advisorsedge@rmpublishing.com Immediate Financing Arrangements can work, IF a client s risk tolerance and tax needs are carefully considered. m at t h e w d a l e y An emerging breed of life insurance plans, commonly known as Immediate Financing Arrangements (IFAs), are akin to Universal Life policies on steroids they can achieve great results, but just like steroid treatments there is proper use and possible abuse. With the help of some sophisticated computer models, IFAs can be made to look like ideal solutions. But remember, illustrations can be misleading and IFAs (or free insurance or positive cash flow insurance as they re sometimes called) require a significant dose of detailed analysis. That said, advisors shouldn t be biased against these sophisticated concepts. In general, we support and promote them and are constantly amazed when the Income Tax Act can be coupled with insurance to create a win-win scenario for the client. But advisors should be wary of using these continued on page AE 29

2 continued from page 29 devices indiscriminately, and must understand the plans and ramifications in order to protect clients from unnecessary risks. A client must consult with his or her accountant, lawyer and tax advisor before entering into one of these plans. Subsequently, it s vital for advisors promoting IFAs to provide as much information as possible to clients, as well as to the clients tax and legal advisors. Advisors are also responsible for outlining all possible scenarios that could occur if the plan does not work as illustrated, or needs to be unwound. The better approach depends on whether your client is more comfortable with investment risks or tax risks. So ask them. The idea of using a life insurance contract for collateral to secure a loan, or to borrow from its cash surrender value, has been around for decades. As many as 30 years ago, advisors were suggesting clients use the cash values in their Whole Life insurance plans to help pay for their homes or their children s university educations. Whole Life insurance operated much like a savings plan and provided important protections in case the insured died before he or she had time to complete the accumulation of assets. Years later, we spoke to prospects about accumulating money in the tax-exempt portions of their contracts so it could be used later to supplement their retirements or the purchase of retirement homes. In recent years, however, borrowing against a life insurance contract has developed a new, robust dimension. And when that s coupled with the interest deductibility rules of the Income Tax Act, these plans take on the look and feel of a tax shelter a convenient way to limit the amount of tax payable on an annual basis, and an efficient and effective way to pay for life insurance costs. An IFA would work well for a client who needs permanent insurance, is subject to a high rate of tax, has significant ongoing income, and is not averse to debt. The client must also understand the ramifications of the plans, together with the advantages and risks. In essence, we re talking about typical highnet-worth prospects. So then, shouldn t might satisfy his or her insurance needs. The Right Pitch these plans be considered by all? Well, just because a client is successful in business and not averse to the occasional gamble, doesn t mean a leveraged insurance strategy is appropriate. And that s especially true if there are safer alternatives that Advisors who want to present these strategies to clients should expect a long learning curve. Since the insurance industry is divided on the best ways to minimize some of the risks, there are three common alternatives to embracing IFAs. Of course, this further complicates the process of explaining the concept as a viable solution for clients. So it s best to present all three methods, including the outlining of differences in structure, tax, and investment risk factors found in each approach. This way clients and their advisors can establish a comfort level and determine the most suitable direction. If it sounds like a lot of work, it is. But the cash deposits made by clients in these cases are substantial, and the risks are considerable. So opt for full disclosure. The inner workings of an IFA are fairly simple. A person or corporation buys a Universal Life policy, or any exempt policy, and deposits a sum of money into it that exceeds the required amount for the cost of insurance. The policy is then used to secure a loan. Here s where it gets interesting. The loan can be either in the form of a collateral loan from a bank, a collateral loan from a credit facility arranged through the insurer, or a policy loan from the contract. Each of the three approaches gives rise to various advantages and administrative procedures, as well as specific sets of tax and financial risks. In the end, the owner of the insurance contract gets back all, or a portion of, the overfunded amount in order to invest in a business or other qualified investment. The one catch is that the investment must produce income, which means paragraph 20(1)(c) of the Income Tax Act will apply and the policy owner should be able to claim a deduction for the loan interest. And, if the investment uses a collateral loan structure, the policy owner can also claim a deduction for the Net Cost of Pure Insurance (NCPI). The deduction is limited to the NCPI for the portion of the coverage equal to the level of the loan. By combining the tax-free accumulation in the contract with the loan advances and the tax deductions, you can offset the actual cost of the insurance. And, in best-case scenarios, the policy can even show a positive return on the investment piece. Letting clients buy their insurance and make a profit, while covering off their premiums is certainly a novel approach. Of course, if the deductions aren t available you might as well call it a day. And the issue of interest deductibility has been a thorn in the sides of advisors who regularly promote this concept. 30 AE

3 Over the years, the CRA has issued a number of technical interpretations relating to the various forms of these arrangements, but has not stated outright that IFAs don t have the intended results for tax purposes. While the plans designers have obtained legal opinions to counter the concerns raised in the CRA s technical interpretations, they re based on how the firm would defend the advisor in the event the CRA decided to take a case to court a sobering thought for any client or advisor. Many insurance companies have structured the arrangement so that there is a link between the interest paid on the loan, along with the interest credited to the amount accumulating in the contract, or so-called special account. And in some cases the loan amount equals the amount in the special account created within the policy. This arrangement negates any real financial risk of interest fluctuations and a mismatch between what is owed and what is in the contract to pay for the loan. Such scenarios create two possible concerns: First, whether a collateral loan could be viewed as a policy loan. Second, if the rates charged and earned are realistic, or have just been built in to make the plan work. Another approach is to let the loan rate float and link the rate of earnings in the contract to the investments selected by the client. The better approach depends on whether your client is more comfortable with investment risks or tax risks. So ask them. Different loan characteristics, such as whether it s a policy loan or collateral loan, also affect how well the plan works. If the structure is based on a policy loan approach, then only an amount up to the adjusted cost base of the policy is available to be borrowed. Anything above that amount would be considered a disposition and thus be taxable. However, if the collateral loan structure is utilized, funds can be borrowed every year first using the amounts deposited into the policy as collateral, then using the earnings in the special account in the policy as additional collateral. Structured this way, the loans can continue to increase and the amounts can accumulate significantly. Once again, the tax risks might be greater in the collateral loan arrangement but the financial outcomes are potentially much more significant. An additional advantage of the collateral loan approach is that the borrower can claim the collateral insurance deduction described in paragraph 20(1)(e.2) of the Income Tax Act. This deduction is available if the assignment of the policy is required by the lender under the terms of the loan and the lender is a restricted financial institution as defined under the Tax Act. Since the premiums must physically be paid, collateral loan agreements are structured with the policy owner actually paying the premiums (the CRA s view is that premiums paid from account values are not actually considered paid for purpose of deductions). A policy loan is not a collateral assignment of the policy, so the deduction is not available with immediate financing policy loan arrangements. Since all IFAs depend on tax deductibility to be effective, advisors must ensure the client can use the tax deductions. The client must have significant and relatively stable taxable income for an extended period of time. As the loan balances grow, the borrower s income must keep up with the increasing deductions. Advisors should consider what would happen to the plan if income were to fluctuate or fail to increase as projected, because if that happens, the deductions may not be fully used. In addition, the tax rate used in illustrations presented to the client should match the borrower s tax rate at the time the deductions are claimed. And then there continued on page AE 31

4 continued from page 31 are the General Anti-Avoidance Rules (GAAR) contained in section 245 of the Income Tax Act. GAAR allows the CRA to challenge avoidance transactions, which are an abuse or misuse of the provision of the Income Tax Act. Arrangements in which financial products are interconnected and interdependent (e.g., a life insurance policy and a loan) may fall into this category, according to a recent technical interpretation (# ). The interpretation is applied particularly in cases where there is no obligation to repay the loan in question and the corresponding interest prior to death. In such a case, the tax consequences could be re-characterized. The plan designers have a reasonable explanation for the rate of interest charged (usually 10%). In the case of collateral loans from the insurer, they also have legal opinions to support the position that the loan is not a policy loan and that GAAR should not be applicable. But, over the past few years, the CRA has been handing out hints that it s looking at these arrangements. In commenting on the relationship between interest loan rates and crediting rates in 2004, the agency said, Clearly the intent of the increased rates is to attempt to provide the policyholder with an increased deduction for interest under paragraph 20(1)(c) of the Act and an increased return under the policy on a tax-deferred or exempt basis. However, in order for interest to be deductible the amount of interest that has been paid or payable must be reasonable in the circumstances. Continuing in the same bulletin, it explained: Apart from the issue of reasonableness, as it would seem that this type of arrangement is not in accord with the purpose and spirit of the provisions in the Act related to exempt insurance policies, we have referred this matter to the Department of Finance Advisors should consider what would happen to the plan if income were to fluctuate or fail to increase as projected. for their consideration. GAAR may also be considered with reference to the interest deductions. According to paragraph 20(1)(c) of the Act, interest on borrowed money used to acquire a life insurance policy is not deductible. If the courts begin to look at the substance and outcomes of these arrangements, it might be considered the funds are being used for the ultimate purchase of an insurance policy and the tax deduction will be lost. Arrangement Options So with all this in play, are IFAs really worth the trouble? Consider the case of 50-year-old Jack, owner of a successful manufacturing business. Jack needs $2 million to fund possible capital gains taxes as a result of the deemed disposition provisions on his death. He could buy $2 million of 10-year term insurance, which would cost him roughly $970,000 by the time he turns 80. Or, he could buy a termto-age-100 plan which would accumulate premiums of about $710,000 by age 80. The net present value (NPV) of the 10-year term at 3% is $496,000, and the NPV of the term-to-age-100 is $470,000 at age 80. Conversely, Jack could enter into an IFA using the continued on page AE 33

5 continued from page 33 collateral loan agreement assuming a 10% loan interest rate and an 8% policy earning rate (these are typical rates for these arrangements). Jack s level cost of insurance would be $24,000 annually and he would pay this for about 15 years. Each year, for 10 years, he would deposit an additional $70,000 to overfund the contract and then borrow this money back. Each year, Jack would pay the interest and then borrow from the investment facility of the insurer at an amount equal to the additional deposit made that year, plus the 8% interest earned in the special account. Then, Jack would reinvest the borrowed funds into his company, and claim the deductions for the interest and the cost of insurance against his income for tax purposes. As the loan balances grow, so does the deductible interest amount. By about the 15th year of the insurance contract, the net cash flow position being offset by the deductions becomes zero. If all works out as illustrated, Jack has paid a net amount of approximately $170,000 after tax for his insurance. If the plan is put into high gear, the net after-tax cost can be reduced to zero and eventually the net cash flow can become positive. When Jack dies, the loan is repaid by the proceeds of the policy and any excess amount is paid tax-free to his beneficiary. So is this a good plan for Jack? The answer is maybe. There are many different ways to design these plans to fit someone with Jack s current and future needs. As such, you will probably end up with reams of paper and options. What Jack and his advisors must be made aware of are the various alternatives on the market and the differences in the structures and designs of the IFAs. They should each be aware of the different tax and financial risks that are associated with the alternatives. Also, consider the factors that affect all of the plans, such as interest deductibility. Although the plans can be unwound, if tax rules change, there could be both financial costs and tax costs to consider. Ultimately, IFAs can be economically They need more income TM Trade-mark of the Canadian Home Income Plan Corporation. panacea. Nothing in life is free, including insurance. And tax planning comes with risks. As an advisor, you must be prepared to present all the structures to clients and tax and legal centres of influence, so that each of those parties can make an informed decision beneficial 3599 AdvisorsEd_Feb for clients, but 4.625x7.5 they re not 1/16/08 a as to 4:53 which PM structure, Page 1 if any, is appropriate. AE brown & weinberger You can unlock the value of their biggest asset One call to CHIP is all it takes We help homeowners 60 and older unlock up to 40% of the equity in their homes without moving. We provide tax-free cash that you can invest to enhance their income. An experienced CHIP representative will answer all your clients questions and complete all the paperwork. You receive a referral fee and the opportunity to invest the proceeds. Find out how you can offer the CHIP Home Income Plan. Call AE 35