10/8 Strategies on CRA radar

The 2008 tax season has a new development. Although nothing has been formally announced, it’s believed the Canada Revenue Agency will be taking a harder look at the leveraged insurance programs — known as 10/8 strategies — being offered by a handful of carriers.

The 10/8 strategy has been around for years, but as was the case with the Singleton Shuffle and the most recent Supreme Court of Canada decision over the Lipson case, it can take time for the CRA to decide whether to rule on complex tax shelters.

“The Canada Revenue Agency has recently become aware of these loan arrangements and we are reviewing them to ensure they comply with the Income Tax Act,” Rebecca Merrett, communications manager with the CRA, confirmed with Advisor.ca.

The CRA would not confirm what it was specifically looking at, although comments made in December at the Canadian Tax Foundation’s Annual Conference offer some insight.

Apparently, a representative from the CRA said that as of January the CRA will be conducting audit initiatives to review tax reporting for insurance companies, such as a verification of insurance company calculations of policy adjusted cost basis (ACB) and net cost of pure insurance (NCPI) amounts.

This means clients currently engaged in 10/8 strategies needn’t worry about the validity of their strategies for the time being. The move by the CRA to audit carriers could be laying the groundwork for an eventual larger audit initiative, notes Doug Carroll, vice-president of tax and estate planning, Invesco Trimark.

Carroll, a tax lawyer who was formerly the head of tax and estate planning for an insurance carrier, says there’s always been some concern in the industry that the interest-deductibility aspect of 10/8 strategies could eventually come under heavier CRA scrutiny.

The typical 10/8 strategy involves a client in the top income tax bracket overfunding an insurance policy with a cash value apart from the death benefit — typically a whole life or universal life policy.

The client then goes to an insurance carrier or a third-party lender in conjunction with a carrier, who provides a loan for a portion or all of the policy’s value. The loan is then reinvested, typically in a small business venture in which the client is already engaged.

The strategy gets its name from the fact that the carrier will carve out the principal value of the loan, and “guarantee” to provide the policyholder an 8% compounded annual rate of return. Because growth within an insurance policy is tax exempt, it will grow tax free. In exchange, the lender will charge 10% interest on the loan, clipping an easy 2% return.

The benefit for the policyholder is that, if the proceeds from the investment loan are in fact put toward legitimate CRA-approved investments, then the interest is tax deductible. That means a policyholder in the highest tax bracket could write off the equivalent of roughly 4% of that interest charge. This creates a net gain for the policyholder when weighed against the 8% growth within the policy.

The policyholder has created a stream of income to fund investments, which would ideally grow in value. They have steady compounded growth within the policy that grows tax free.

All of this is a gross simplification. Implementing the strategy requires considerable consultation with tax experts.

“The 10/8 strategy flies in the face of a lot people’s views of taxation. The calculations do fall within the tax rules,” Carroll says. “The way the different components are put together is not the way those rules were intended to operate for this kind of arrangement.”

If the CRA has a bone to pick, Carroll suspects it will be on the interest deductibility, in an arrangement that already includes tax exemption within the policy. He suspects the government will be taking a look at the 8% rate of return offered by carriers, which is a very attractive proposition in today’s market.

“The lender will give you an 8% permanent rate of return. Over a long-term arrangement, those become pretty big numbers. [I suspect] the CRA would have to do more of an in-depth analysis on that,” he says. “How do you justify those kinds of numbers in today’s environment, in that tax-free package?”

Carroll also notes that the CRA may find nothing wrong with the strategy and affirm its usage. Either way, he says, it’s not of tremendous importance for the CRA, and he expects it will be a long process of analysis.

“They may come to the determination that you can manage your affairs using this type of arrangement,” he says. “Right now it looks like early stage information gathering to understand the arrangement. It’s a very complicated issue and [10/8 strategies] are pretty isolated in terms of who can make use of this. It’s not surprising they have taken time to decide to look at them.”

(01/14/09)