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Ottawa has finally closed the door on Leveraged Annuity and 10/8 Insurance strategies. Here's what you need to know.
By: Asher Tward, VP Estate Planning–TriDelta Financial
If you are a high net worth Canadian, you may not yet be aware of the tax code changes introduced in Thursday’s federal budget that could dramatically affect your long-term financial planning. Ottawa has finally closed the door on Leveraged Annuity (Triple Back-to-Back) and 10/8 Insurance (Front End Leveraged Insurance) strategies. These strategies have been hawked by advisers for many years and many wealthy investors have found them hard to pass them up. Now these same investors, along with their accountants and advisers, are being forced to close them down and revamp their financial plans as Finance Minister Jim Flaherty attempts to make good on his promise to crackdown on “aggressive tax planners.”
I will stick to the less complex 10/8 Insurance model here, and tackle the Leveraged Annuity strategy at another time.
The written explanation of the changes provided by the Department of Finance covers the implications for a client who has gotten involved in one of these sophisticated plans, most of the them high net worth Canadians with $5 million or more in assets. In general, the government has given investors until 2014 to wind down these programs with limited tax implications as a result of a one-time amnesty.
Wealthy Canadians have been using 10/8 arrangements for the last decade or so as a means to have the government subsidize their extremely large life insurance policies. The problem is that they are highly sophisticated structures that require a few moving parts to all be working.
• The basic concept is that an investor takes out a life insurance policy, and invests a huge amount of money into it.
• The policy then allows them to borrow against 97% of that money right away. Therefore, there is very little capital actually tied up in the plan.
• The borrowed funds are supposed to be used for outside investments that will generate a return in excess of the 10% interest rate being charged by the insurance company. If this is done properly, the 10% is fully tax-deductible, making the net cost of borrowing only 5.5%. This interest is paid to the insurance company every year.
• All of the money that was deposited into the policy grows tax-exempt at a guaranteed 8%. Thus, there is a 2.5% benefit for the investor each and every year against the total capital committed to the plan. Many of these plans have more than $1 million in them, and the government is subsidizing their $25,000 net tax benefit each and every year, except it is costing the government $45,000.
• The insurance company also takes their fees and insurance costs out of the pool of capital each month, which depleted the cash values.
These plans were structured in such a way as to maximize the investor advantage with little regard for the longer-term drawbacks. Namely, it would be next to impossible to pay off the policy loan with capital inside the policy without incurring punitive tax consequences.
Luckily for affected investors, the government will waive all tax liability on the settlement of the loan balance using available funds within the policy—if this is done before 2014. This is a significant and generous surprise, given that these investors have made out huge over the years already. Collectively, these plans likely have over $1 billion invested in them, based on the government’s tax saving assumptions of $260 million over the first five years alone. I can reasonably assume the government had little choice but to offer a grace period. Had they not provided the temporary tax exemption there would have been massive law suits against advisers and insurers.
Still, there remains significant liability as a result of these changes. One of the negative elements of these plans is very high surrender charges. A surrender charge is a hold back amount that an insurer charges against the cash values of a life insurance policy for the first 8 to 10 years, if funds are withdrawn early. This is where I see some massive problems brewing for high net worth Canadians and the advisers that made huge commissions selling these products. If you took out a plan like these 10 years ago, you were able to get your tax-deductions and make your 8% return tax-free—and there are no surrender charges upon collapsing the plan now. Therefore, you are able to get out pretty clean and had a subsidized insurance policy for 10 years. However, many Canadians used these plans for their own estate planning vs. just as an opportune investment. Now they will have to decide what to do, as the premiums may not be affordable and the insurance may be over inflated.
Needless to say, there are going to be a lot of high net worth Canadians in need of sound advice over the next nine months. Affected individuals and accountants should seek out the proper advice though it may not be come free. Someone is going to have to do some hard work to put the pieces back together and ensure that their long term plans remain intact despite the destruction of this deceptively powerful tax planning strategy. There are further negative implications for those who carry these plans inside a corporation. I would suggest that the adviser who sold the product may not be the right person for the job—however, that is a judgement call. If the tax risk was fully disclosed and a client still chose to take the risk, then the adviser is not entirely responsible.
In my opinion, 10/8 Insurance strategies were doomed from the start because they allowed insurers and investors to generate income at the expense of the government. The CRA and the Department of Finance have been telegraphing this for years. Any pragmatic and sophisticated adviser should have seen it coming.
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