Leveraged insured
life annuities can be tax-effective estate-planning tools for clients who own all the shares of a private corporation and wish to generate positive cash flow, reduce capital gains upon death and generate tax-free capital dividends.

LILAs are suitable for business owners age 65 or older who have significant value associated with ownership of shares in a corporation that will result in substantial capital gains upon death, says Kevin Wark, senior vice president, business development, in the national office of Toronto-based PPI Financial Group Inc.

“They are also useful for maximizing after-tax income while preserving estate values,” says Geoff Burman, president of Burlington, Ont.-based Broker Advantage Inc.

LILAs, also known as “corporate insured life annuities” or, more commonly, as “triple back-to-back annuities,” have three components: a life annuity; a life insurance policy, which is a term 100 or a minimum-funded universal life; and a loan.

The structure of LILAs can include subsidiaries and holding companies owned by the shareholder, but the objectives of variations in structure are generally the same. Here’s how they work:

> The annuity. Typically, a corporation uses cash from its operations or the proceeds from liquidating other corporate-owned investments to purchase an annuity that provides income for the duration of the shareholder’s life. Some annuity contracts have a guarantee period that provides payments to a spouse on a second-to-die basis.

> The insurance policy. The company buys an insurance policy on the shareholder’s life. The beneficiary of the life insurance policy is the corporation, which also owns the annuity contract.

> The loan. The corporation then takes out a loan from a bank to replenish its operating capital, repurchase investments that were liquidated to purchase the annuity and the insurance or to distribute capital to the shareholder. It is usually a term loan with a fixed interest rate, with a requirement that the interest cost be paid during the term of the loan. Normally, the frequency of the insurance premiums, annuity payments and loan payments must be synchronized. The insurance policy and the annuity are used as collateral for the loan.

“The income paid by the annuity is used to fund the insurance premiums, pay the interest charges and provide cash flow to the corporation,” says Florence Marino, assistant vice president, tax and estate planning, with Manulife Financial Corp. in Waterloo, Ont.

In some cases, income from the annuity may be insufficient to cover the costs. “The
younger the shareholder, the less likely it will be that the annuity payments will be sufficient,” says Wark. “This could also result from interest rate fluctuations on the bank loan vs an annuity with a fixed rate.”

If this is the case, the bank may require additional security or the shareholder’s personal guarantee. Marino advises that the corporation should have sufficient income and cash flow to meet resulting deficits.

To realize maximum benefits for the corporation, the borrowed funds must be used to produce income so interest on the loan will be fully deductible. However, the corporation’s taxable income from the annuity and from investing the proceeds of the loan must at least be equal to the loan’s interest expense to merit full deductibility.

The taxable income from the annuity will be greater in early years and diminish in the contract’s later years, when the return on capital is higher. This will have an impact on the interest expense deduction of the corporation over time, based on the flow of income vs the return of capital. On the whole, “interest deductibility is subject to scrutiny and a reasonable expectation that income earned will exceed expenses incurred,” says Burman.

> The shareholder’s death. Upon the death of the shareholder, all or part of the insurance policy is used to repay the balance of the loan, eliminating the corporation’s debt to the bank. Anything in excess of the loan is paid to the corporation. Proceeds returned that are in excess of the adjusted cost base of the insurance policy are treated as a credit in the corporation’s capital dividend account. The ACB is the total premiums paid less the net cost of pure insurance. The CDA is a notional account inside the corporation in which non-taxable credits are deposited that can flow tax-free to the shareholder.

@page_break@For tax purposes, the deceased is deemed to have disposed of shares of the corporation at fair market value immediately before death, incurring potential capital gains taxes.
“But, for purposes of determining fair market value, the valuation of the corporation’s shares would be reduced by the outstanding loan,” says Marino. “This effectively reduces or eliminates the capital gains tax payable.”

When the shares are redeemed upon death, says Marino, the Income Tax Act deems the proceeds a dividend to the extent that the proceeds of redemption exceed the paid-up capital of the shares. The dividend is paid to the shareholder’s estate or heirs as a tax-free capital dividend based on the balance of the corporation’s CDA account.

For tax purposes, she adds, no value will be attributed to the life insurance policy, which will have little or no cash surrender value. If the annuity contract has no guarantee payment period and is non-transferable, it will also have no value. However, if there is a guarantee payment period, the Canada Revenue Agency may attach a value to the annuity based on the life expectancy of the annuitant and the then-current value of the remaining stream of payments. But the value decreases as the shareholder ages, so it could be small.

Generally, a life insurance policy’s premiums are not deductible for income tax purposes. However, LILAs may benefit from an exemption. When money is borrowed from a bank to earn income, and the bank requires the assignment of a life insurance policy as collateral security, the CRA may allow an expense deduction equivalent to the lesser of premium payments and the net cost of pure insurance.

“Triple back-to-backs are complex and are subject to a variety of risks,” says Philip Kung, president of Markham, Ont.-based RGI Financial Services Inc. “The structure must be well thought out in order to reduce or avoid risks.”

Marino adds the plans are “generally not flexible planning tools and cannot be easily undone.” In terms of the life insurance policy, premium payments are required to keep the policy in force and the benefit is available only on death. The annuity is a fixed-rate investment for the lifetime of the individual and cannot be cashed in. “If the corporation wants to repay the loan before death, the funds will have to come from other sources such as liquidation of assets or corporate cash flows,” she adds.

There is also interest rate risk, says Wark: “If the loan has to be renegotiated at the end of a fixed term, rates could be higher, increasing the cost of borrowing and reducing cash flow.” Alternatively, cash flow could be improved with a lower interest rate.

It is also possible that the fair market value of the corporation would not be reduced as a result of this strategy. “What if investing the loan increases the corporation’s value to the extent that it offsets the planned reduction of the corporation’s fair market value?”
asks Kung.

Another risk is that the CRA would deny the CDA credit or interest rate deductions. And transactions involved in setting up a LILAs should not be perceived as trying to avoid taxes or abusing Income Tax Act provisions.

“Taxpayers are entitled to structure their affairs in a tax-effective manner,” says Marino. But a LILA’s purpose and structure must be fully understood if your client hopes to maximize shareholder or estate benefits. IE