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Collateral Insurance Deduction: When and How?



Generally, premiums paid under a life insurance policy are not considered an allowable deduction for income tax purposes, but there do exist certain circumstances whereby a policy owner may claim the collateral insurance deduction. Although this opportunity for deduction may provide an incentive to move forward with a particular strategy (specifically in the IFA), it’s important to understand how the deduction works and what are the limitations to avoid overstating its significance.


What are the requirements for deductibility?

A borrower may claim a collateral life insurance deduction if:

  1. 1An assignment is required by the lender under the terms of the loan agreement;

  2. the lender is a “restricted financial institution (RFI)”, as defined in the Act;

  3. The policy is assigned to the lender;

  4. the interest payable in respect of the debt is deductible in computing income for the year for tax purposes.


An assignment is REQUIRED by the lender:

The lending terms must strictly reflect the lender’s requirement that the borrower assigns a life insurance policy as collateral for a loan. A written request from the lender asking for this assignment is sufficient evidence that this requirement has been met. Based on CRA’s practice, it appears that this requirement must be satisfied in each taxation year that the deduction is taken. On another note, the policy doesn’t have to be new to qualify and can be either term insurance or a cash value policy. Prior to 1990, only term insurance was permitted. Even though a lender may accept a policy from one entity as security for a loan given to another entity, the policy owner and the borrower must be the same person or entity for the collateral life insurance deduction to be available. This is why the collateral insurance deduction IS NOT available in a Corporate Insured Retirement program scenario with “Personal/Shareholder” borrowing. In this scenario, we have a corporate policy owner but a personal (shareholder) borrower.


Must be a Restricted Financial Institution (RFI):

An RFI is generally defined as a bank, trust company, credit union, insurance company, and corporation whose principal business is arm’s length lending. As a result of this requirement, insurance used as collateral security in respect of shareholder loans would generally not be eligible for the deduction.




Insurance policy is assigned to the lender:

The insurance policy must be “collaterally assigned” to the lender. The policyowner/assignor maintains certain ownership rights in the policy, but the “value” of the policy (i.e., the cash value or the death benefit) must first be used to satisfy the debt owed to the lender/assignee. Any remaining amounts may then be paid to the policyowner/assignor, or upon death to the beneficiary. A “collateral assignment” is different from an “absolute assignment” of a life insurance policy which involves the assignor transferring all ownership rights in the policy to the assignee, retaining no interest. This type of assignment (absolute assignment) is considered a policy transfer and therefore may trigger taxes.


Interest payable must be deductible for tax purposes:

For the collateral insurance deduction to apply, “interest” payable on the loan secured by the life insurance must be deductible for tax purposes as well. For interest payments to be considered deductible for tax purposes, the loan proceeds must be used for business or investment purposes that create taxable income.


Calculating the amount of the collateral insurance deduction:

Assuming these 4 requirements are met, the amount of the collateral insurance deduction is calculated as follows. First, the deduction may not be more than the lesser of (A) Premiums payable for the year and (B) the Net cost of pure insurance (NCPI). Second, only a portion of the lesser of these 2 amounts is deductible each year relative to the loan outstanding and the death benefit. Here’s an example: assuming the loan outstanding is $500K and total death benefit equals $1 Mil. Only 50% of the lesser of the NCPI or premiums for that given taxation year is deductible for tax purposes. Even though tax-deductible dollars are used to pay the premiums, the death benefit proceeds received on the death of the life insured remain tax-free.


Not all products are created equal: Universal Life vs Participating Whole Life vs Non-Participating Whole Life:

Here’s where things get interesting. CRA has confirmed that the “premium payable” requirement corresponds with the premium the policyholder chooses to pay the insurer under the terms of the policy and the amount the insurer withdraws from the accumulation account of a Universal Life plan to cover the cost of insurance and related fees DO NOT CONSTITUTE premiums. What this means in the case of Universal Life, there is only a “premium payable” in the years where the policyowner makes an ‘out of pocket’ payment into the policy. This is not the case for Participating Whole Life Insurance. The amount of each premium is specified in the contract, satisfying the CRA requirement that premiums are payable even when a policy is on “PREMIUM OFFSET”. In addition, CRA has also confirmed that the method by which premiums are paid does not determine the amount deductible. This extends to premiums being paid with policy dividends and surrendering paid-up additions. It’s important to distinguish between Participating WL and Non-Participating WL (non-par) when it comes to the availability of the collateral insurance deduction. Non-Par WL is treated the same as Universal Life in this category and therefore collateral insurance deduction is only available when the policyowner makes an ‘out of pocket’ premium payment and NOT when the Non-Par WL is on premium offset.


So where does this come into play? Well, you guessed it! …..Immediate Financing Arrangements (IFA). In addition to being able to deduct interest costs for tax purposes, another important feature is the ability to have access to the collateral insurance deduction, particularly in the life insured’s later years when the NCPI amount becomes more significant. Choosing a plan design that allows one to maximize this feature is critical in making this strategy work in the most tax-efficient way. Here’s a sampling of available IFA insurance plan designs and their access to the collateral insurance deduction (illustrating 10 identical yearly deposits/payments):

  1. A “Limited 10 pay Par Whole Life” (receiving policy dividends) will only have 10 years’ worth of collateral insurance deductions available.

  2. An “Overfunded Universal Life using a level COI option” but structured with 10 yearly deposits will also only have 10 years’ worth of collateral insurance deductions available.

  3. A “Life Pay Non-Par Whole Life” (receiving performance credits) with premium offset in yr. 11 (so 10 payments) will have only 10 years’ worth of collateral insurance deductions available.

  4. A “Life Pay Par Whole Life” (receiving policy dividends) with premium offset in yr. 11 (so 10 payments) will have a LIFETIME’s worth of collateral insurance deductions available.


The only way to truly measure the importance of the collateral insurance deduction in an IFA scenario is to run the various solutions concurrently and weigh the results. All else being equal, the plan design that produces the best IRR (relation between net cash flow to net estate benefits) in a “SERVICE THE DEBT” scenario is the most optimal solution. In a “ZERO CASH FLOW” (or refinancing the interest payments) scenario,…you’ll need to look for a solution that produces the best net estate benefits. In addition to this, you’ll need to assess the ability to satisfy the additional collateral requirements of each solution since they will vary.


Although the collateral insurance deduction is only one of several variables/components that need to be considered before deciding which plan design to implement in an IFA strategy, I would argue, that access to the collateral insurance deduction is one of the more important ones,…especially in the later years.



Tony Gallippi, B.A.S (Hons.) CFP CLU


Director, Advanced Planning, Insurance


QFS









This communication reflects the views of Qualified Financial Services Inc. as of the date published. The information in this publication is for general information purposes only and is not to be construed as providing individual legal, tax, financial or other professional advice. Qualified Financial Services Inc. assumes no responsibility for any errors or omissions in the information contained herein nor for any reliance placed on such information. Please seek independent professional advice before making any decisions.


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