By: Florence Marino B.A., LL.B., TEP | Vice President, Tax & Estate Planning
In August 2024, the CRA updated its Folio on Interest Deductibility (Income Tax Folio S3-F6-C1, Interest Deductibility – Canada.ca) and generally confirmed its existing interpretations and positions. So, it is probably a good time to provide a review of interest deductibility in the context of leveraged life insurance.
Some background
The use and recommendation of leveraged life insurance (sometimes referred to as Insured Financing Arrangements “IFA’s”) has grown significantly over the last decade. It is a concept that is viable for certain sophisticated clients but is not necessarily a fit for every client, and, as such, should be carefully considered. The concept itself is not difficult to understand. Like any asset of value, life insurance cash values can be used as collateral security for a loan. If the borrowed money is used for the purpose of gaining or producing income from a business or property, interest on the borrowed funds may be deductible.
Interest deductibility is but one “assumption” that is part of a leveraged life insurance plan. Another is whether the borrower will have sufficient taxable income into the future to absorb a growing amount of interest expense. In this article we’ll dive into these and other assumptions as well as the pertinent details in the context of a newly purchased whole life insurance policy that is used as collateral security by the policyholder for a loan shortly after it has been purchased. What mechanical steps are being assumed to occur, and that must occur, for that assumption to be true?
What’s the use?
To achieve interest deductibility, the borrowed funds cannot be used to pay the premium under a life insurance policy. The life insurance premium – the first and all subsequent premiums – must be paid out of pocket by the policyholder. In the context of a corporation, this means operating capital, cash or near cash assets on hand are used to pay the premium. The policy’s cash value may then be used as security for a loan to the corporation to purchase operating assets, an investment or income producing property.
The direct use of the borrowed funds must be linked/traced to a business or property acquired “for the purpose of gaining or producing income”. This does not import a “reasonable expectation of profit” test. In 2003, there was an attempt to legislate this test into the interest deductibility rules which was subsequently withdrawn in 2014. So, there is no requirement that the amount of income earned on an investment be higher than the interest charged on the loan nor is the amount of interest that is deductible, restricted to the income earned from the investment. The interest must be a “reasonable” amount though!
However, “reasonable expectations” do enter into some of the analysis. Capital gains are not “income” for these purposes. So, if the investment into which the borrowed funds are traced, have no expectation of income and only capital gains, interest deductibility may be denied. However, the CRA does take a pragmatic approach. For example, in the case of borrowing to purchase common shares, the CRA states in paragraph 1.70 of the Folio, if there is a “reasonable expectation that the common shareholder will receive dividends”, interest will normally be deductible.
Some exceptions to the direct use test are permitted (see paragraphs 1.45-1.58 of the Folio). Borrowed money may be used by a corporation to redeem shares, return capital or pay dividends where “the borrowed money replaces capital (contributed capital or accumulated profits) that was being used for eligible purposes that would have qualified for interest deductibility had the capital been borrowed money.”
Paid or payable – Simple and compound interest
For simple interest to be deductible it must be paid or payable in respect of the year pursuant to a legal obligation to pay interest. A taxpayer who uses the cash method of reporting may deduct interest in the year that the interest is paid. A taxpayer using the accrual method may deduct interest in the year that it is payable. For compound interest – interest on unpaid interest – it must be paid to be deductible.
In leveraged life insurance projections, what is being assumed regarding the payment of interest? These projections often assume that interest is paid out of pocket and then a borrowing is made in an amount equivalent to loan interest after tax savings (i.e. interest deductions and potentially the relevant portion of the premium or net cost of pure insurance) are applied. And that borrowed amount is then used to invest for an eligible purpose so that the interest on this loan is deductible. This also would result in no compound interest arising. And would result in a growing loan amount outstanding, which, if not repaid during life would be repaid on death from life insurance proceeds.
Paying continuing premiums on life insurance and ongoing service
As premiums are paid and cash values grow within a life insurance policy, the same mechanical steps can be undertaken each year. As stated before, borrowed funds cannot be used to pay premiums if interest is to be deductible. Existing investments purchased with borrowed funds from prior years cannot be liquidated to provide the cash to pay a life insurance premium without the interest deductibility on the prior borrowing being lost.
Proper maintenance will enable continued interest deductibility. However, as more and more borrowings are made, the loan amount and related interest amounts will grow. It is important to question if the taxpayer has and will have sufficient income to use the interest deductions and at what tax rate? Now and into the future.
Changes in interest rates will move more quickly based on the movement of prime rates than will any change in dividend scales of whole life policies. Running the IFA model projections with increasing or decreasing interest rates will provide an understanding of this sensitivity. The underlying whole life policy requires annual monitoring and reporting to gauge these variables over time. Finally, it is important to work with an insurance advisory firm that has the infrastructure to provide clients with this type of detailed annual reporting and projections.
Other tax issues and impacts on interest deductibility
When dealing with high-income, individual policyholders/borrowers, alternative minimum tax (Alternative minimum tax – Where are we now? – Tompkins Insurance) should also be considered. Only 50% of interest and financing expenses are allowable for AMT purposes.
When the policyholder is a Canadian corporation that is part of a group that includes a non-resident entity, interest deductibility could be limited by the excessive interest and financing expense limitation (EIFEL) rules. Specialized tax advice and guidance is required to determine if there is an exclusion from these rules and where they do apply, whether and how, expenses can be used, carried forward/back within the group.
Our thoughts
Testing and crash-testing assumptions is important. Moderation is prudent.
Professional tax advice has got to be engaged to verify that the assumption makes sense and ensure the steps are actually taken to carry out the mechanics. This must be partnered with insurance advisory client service.
Nuts and bolts matter.
FOOTNOTE:
This publication is protected by copyright. Tompkins Insurance is not engaged in rendering tax or legal advice. TOMPKINSights contains a general discussion of certain tax and legal developments and should not be construed as tax or legal advice.
Should you wish to discuss this or any other TOMPKINSights article, please contact
florence@tompkinsinsurance.com
