The department of Finance is revisiting the so-called “exempt test” rules for universal life insurance policies to account for potential tax leakage in certain product designs.

“They’re looking around and they’re asking: ‘How much [tax revenue] are we losing?’ and ‘Can we recover it?’” says Jim Kraft, vice president, financial planning services, insurance, with BMO Life Assurance Co. in Toronto.

Exempt UL policies are generally used for estate- and tax-planning purposes. What makes them unique and problematic is their associated investment accounts. In these accounts, invested assets can grow and escape annual taxation, which would have occurred had the assets been held directly.

Tax law gives policyholders of exempt UL policies reprieve from annual income reporting for this associated investment account. Instead, the insurance company pays a percentage-based investment income tax on the tax-sheltered accumulation. But, ultimately, the policyholder pays the taxes because their cost is built into the cost of the policy.

The exempt status of these policies has always had limits. The UL policy must meet certain mathematical criteria in the exempt test — annually, for as long as the policy is in force.

This test includes a calculation involving the relationship between the policy’s death benefit and the accumulated value of the investment account — as well as assumptions about mortality rates, interest rates and the insured’s age, gender and health.

HIGHER SURRENDER VALUES

One concern relates to certain product designs that may suppress the cash surrender value, potentially leaving some taxable income on the table, says Kevin Wark, senior vice president of business development with Toronto-based PPI Financial Group Inc.: “There are product designs out there that are probably of concern to Finance.”

Specifically, a few insurers have introduced high surrender charges. The surrender charge is a fee that the policyholder pays to the insurer if the policyholder cancels the policy and walks away with its accumulated value.

The surrender charge, which decreases over time, comes off the cash value of the policy and keeps the policy within the limits of the exempt test. Because of the way the exempt test ratio works, the surrender charge allows the policyholder to accumulate more cash.

These policies can be especially tax-efficient because policyholders can fund their policies to the maximum every year — and, assuming the policyholders make some income off the investments, Wark says, they can actually pay off the premiums for their policies with pre-tax dollars. “So, these policies with high surrender charges,” he says, “allow you to put money in quicker, accumulate more tax-deferred [income] and stop paying premiums earlier.”@page_break@Currently, the exempt test judges a policy’s investment account against a fictional benchmark policy that’s known in the industry as a “20-pay endowment at age 85.” To explain: assume a 50-year-old man buys a UL policy with a face value of $100,000 and starts accumulating cash and income in the policy’s investment account. To pass the exempt test annually, this fictional policyholder must be able to divide his policy’s investment account into 20 payments to age 70, and then assume simple compounding for another 15 years to the age of 85. At that point, premiums plus interest must be equal to or less than the $100,000 death benefit.

In other words, the cash surrender value of your client’s UL policy when your client is 85 years old cannot be greater than that of the fictional “20-pay” policy. Any deposits into your client’s UL policy’s investment account — plus all the accumulated income — must be equal to or smaller than the accumulation in the fictional policy.

Ronald Sanderson, director of policyholder taxation and pensions with the Canadian Life and Health Insurance Association Inc. , says Finance is asking if “the number crunching is as accurate as it needs to be?”

TIGHTER RULES?

He notes that the rules concerning tax exemption go back to the early 1980s, and there has been much back and forth between the insurance industry and the government. Before the Canada Revenue Agency issued a technical interpretation around 2003, it was more difficult to conduct the exempt test. Instead of using the more simple cash surrender value, a longer, actuarial calculation had been used.

In situations in which the policy’s death benefit and the premiums were variable, the actuarial calculation was more accurate. The feds could also review a number of the test’s elements, Sanderson adds, including assumptions about long-term interest rates, mortality and the usual actuarial variable.

The investment income tax is another important variable that could change. Today, UL policies’ investment accounts are taxed at the rate of 15% of the 60-month average on the value of government bonds. Wark says Finance could fiddle with that figure: “It could be a higher expense charge.”

And given the variables, he adds, you could anticipate tighter rules: “There would be fewer opportunities to accumulate the same cash values on a tax-deferred basis.”

Insurance companies generally agree in their contracts to make sure a policy passes the exempt test for the policyholder. The variables in the test allow insurers, for example, to adjust the value of the death benefit automatically to compensate for the accumulation of cash in the investment account. The insurer can also return cash to the policyholder as a partial surrender of the cash value; this payment may be subject to some taxes. Insurers have 60 days from the anniversary date of a policy, Kraft says, to do so.

Sanderson says that in today’s fiscal and economic environment, it’s no surprise the UL exempt test has come under scrutiny again. But, he adds, no announcement about changes is imminent and any changes are likely to “grandfather” policies already in force.

In the meantime, the feds always want to know how big the product is in the market and how it’s being used, he adds: “There’s been more activity in the past year. But to suggest that Finance is about to make a decision is [taking it] a bit far.”

IE