Should clients drop 10/8s?

10/8 insurance arrangements offer Canadian investors unfair tax advantages.

So says Budget 2013, which aims to level the field at tax time by cutting the benefits these policyholders are offered.

Read: The party’s over for tax-advantaged investing

Under 10/8 arrangements, clients invested in life insurance policies with the intention of borrowing against them at a 10% interest cost. They were then guaranteed credits to their policies of approximately 8%.

The CRA considered 10/8 loans as investment-related prior to the budget, so the after-tax costs of borrowing fell to 5.5% or less. Tax deductions were determined annually, with people saving 45% of 10%, or 4.5%. This resulted in a net cost of 5.5%.

This strategy was traditionally marketed to closely held private corporations and wealthy customers.

Read: Insurance for wealthy clients

That’s because buyers had to make substantial deposits for the 10/8 loans to be taken out in the first place, says Byren Innes, senior vice president and director of New Link Group. He adds people generally bought their policies for upwards of $5,000,000, with premiums running at $100,000 for several years.

It was a profitable strategy, adds Innes, and therefore drew the attention of the government and CRA. The budget states, “In the absence of the tax benefits, the investing and borrowing would not [have been] undertaken.”

So, CRA proposed to deny the following benefits as of March 21:

• the deductibility of interest paid or payable on the borrowing that relates to a period after 2013;
• the deductibility of a premium that is paid or payable under the policy that relates to a period after 2013; and
• the increase in the capital dividend account by the amount of the death benefit that becomes payable after 2013 under the policy and that is associated with the borrowing.

Read: Budget 2013 looks a lot like 2012, for insurers’ initial reactions to the budget

What’s more, CRA didn’t grandfather 10/8 arrangements entered into prior to Budget Day. Instead, all of these policyholders are being encouraged to wrap up their loans by repaying them before January 1, 2014 without income tax consequences.

A surprise to the industry

In CALU’s post-budget report, it said, “CRA has been “unhappy” with certain leveraged insurance arrangements for a while. In particular, leveraged insured annuities and 10/8 programs.”

However, it adds the agency has “struggled to get traction in both identifying and creating assessing positions that it felt would be supported in Court if challenged by taxpayers.”

This is why industry players and advisors alike were surprised when the budget’s proposals came down the pipe. The report says CRA’s proposed measures are “very targeted [and] designed to eliminate most, if not all, of the benefits of such arrangements. We will be consulting closely…on these proposals to determine our response to Finance.”

Further, CALU president Kevin Wark says, “Industry players had made efforts to educate both the CRA and Finance on the nature of the [10/8] loan program” and its benefits over the last few years.

Read:

Budget 2013: Not much good tax news

CRA review of 10/8 insurance programs (2009)

Overall, he says the market for 10/8 programs is much broader than that of leveraged insured annuities—which were grandfathered if entered into before Budget Day.

LIAs combine an annuity, a life insurance policy and a loan within a private corporation. Rather than using company capital, business owners use the loan to purchase their insurance and then write off the interest. They’re typically held by shareholder age 60 and over.

In contrast, 10/8s are held by customers of all ages, as well as by these older business owners.

Read: Help business owners succeed

Wark adds, “In the vast majority of 10/8 cases, the insurance was purchased for an estate-planning or business succession need.” The leveraging program was only an option, but Innes says it was likely difficult to pass up due to the tax savings available.

Options for policyholders

For clients to wind up their 10/8 loans, they would need sufficient capital.

This is important because the loans don’t have payback schedules, says Innes.

Read: Beware leveraged loans

He adds, “The loans are [often] set up to never be paid in cash, but rather be paid off from the proceeds at death. In this way, the loan balances would be deducted from the tax-free proceeds of a death benefit.”

Further, “As long as the asset purchased with the loan qualified as an investment opportunity, the interest would have continued to be deductible. So paying off the loan would not be desirable.”

Insurers also needed to collect the 10% interest payments to be able to credit the 8% to the policies.

Continue on to find out how clients can deal with their loans, as well as how to discuss 10/8 policies with them.

If you have older clients who wish to pay off their 10/8 loans, Wark says, “Most of these policyholders [should] have relatively good cash flow from employment, investments, or their business, and therefore would have access to other assets if needed to repay…the loans without necessarily pulling funds from their policies.”

The budget proposal gives people less than a year to wrap up the loans without consequence, so you may find customers are looking for more immediate access to cash to service their loans. These types of assets will provide the needed funds, and their policies will remain unaffected.

Innes suggests clients could borrow from their corporations to pay off the loans. They would then have the basic insurance policies they started with.

Then, they could take out regular policy loans instead if they want to borrow to invest. These loans are often available at 4%-to-5% interest.

Read: Two ways to deduct interest

The benefit of this approach is the policyholders’ costs will be roughly the same as under 10/8s. Say your client has a $1-million policy loan with carrying costs of $100,000. She would have paid about $55,000 a year in net interest for the 10/8 arrangement.

If she switches to a normal loan, however, she’d shell out approximately the same amount—or less—since borrowing rates are 4%-to-5% on average currently.

The drawback? Since interest rates are approximately 1%-to-3%, she’ll also earn a lot less if the money just sits in safe investments. The new policy would earn at most $30,000 a year as opposed to the previous $80,000. “It’s not an ideal situation for anyone,” says Innes.

Another issue: many 10/8 holders would likely have used their high policy earnings to help offset the costs of insurance in their policies, though they’d have lower cash values as a result of using these earnings to cover costs.

Read: The price is high…for now

When a client only earns 1%-to-3% on her cash values, on the other hand, she might not make enough to cover the cost of insurance and also profit from her investments.

Clients with no capital

If business owners or wealthy customers invested in volatile markets or if their companies suffered over the past few years, they may not have a lot of money today.

If your clients don’t have the capital to wind up their loans, they’ll have to instead withdraw the funds from the cash values of the policies. CRA will allow this until January 1, 2014 without tax consequence by not deeming the cash withdrawn as part of their incomes.

Read: Deconstructing wealth

Innes says cash values can generally be accessed three ways:

• clients can cancel their policies and collect the proceeds after all costs are deducted;
• they can make withdrawals based on what’s accured in their accounts; or
• they can take out a policy loan.

In the case of 10/8s, Innes hopes insurance companies will find a mechanism to let clients simply change the 10/8 loans to general policy loans.

Cash value withdrawals come at a cost, however. They’re also only permitted under universal and whole life policies, says Innes.

For those who plan to keep their policies, the first drawback of depleting cash values is that they’ll have to lower their death benefits, or raise their premiums to keep the same benefits levels.

Read: Increasing estate values for the affluent

Clients with newer policies also face challenges. If they try to cancel their coverage and look for new plans, they may face high surrender charges. They’ll also have less cash available since it hasn’t built up over time.

This means after deductions and fees, they may not have enough capital left to pay off the loans completely.

What’s more, policies held for less than three years that are cancelled or reduced are subject to commission reversal, says Innes. On a $5,000,000 policy with a $100,000 premium, the advisor and distributor could have earned as much as $45,000-to-$60,000 depending on the age of the client.

The seller would normally be required to payback a pro-rated portion of this based on the terms of their broker’s agreement. Similarly, the fund values in the policy have surrender charges that normally run over 10 years. These are high in the early years of the policy, and these charges would impact the surrender value of the plan for your client.

Companies who have sold 10/8s will have to wrestle with these challenges and seek the best outcome.

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Sticking with the loan

If your client can’t drop his policy, or pay off or swap the loan to a general one, he’ll have no wiggle room until legislation is worked out.

Providers say they’re currently in talks with the government and CRA to come up with solutions and options for their customers, and they’re keeping the one-year, tax-free deadline in mind.

For now, say you have a client with a $100,000 loan at 10%, and at a 45% marginal tax bracket, says Wark.

If this customer is “paying all the interest out of pocket…the interest [deduction] would [now] be disallowed and the after-tax cost would be equal to that actual cost of $10,000.”

That said, Wark says, “They would still benefit from the $8,000 growth in the policy cash value, as well as the return on the underlying investments acquired by the loan.”

There are alternative leveraging strategies to consider, and Wark adds arrangements can be “restructured to minimize the negative tax impacts. Every situation needs to be reviewed based on a client’s long term planning needs”, as well as their policy agreements.

What to tell clients

Wark says, “It would be premature at this stage to make changes to 10/8s until the industry has had a chance to consider the legislation in more detail.”

Read: Budget 2013: A client letter

Also, “due to recent increases in the [price] of level cost insurance coverage under universal life policies, it will often be in the policyholder’s best interest to retain his current coverage even if he withdraws some or all of the account value to repay the loan.”

Wark warns some providers may come forward with new options and alternatives to 10/8s, but “the worst thing to do would be to encourage a client to take reactive action” before they weigh their options and the potential consequences.