Among one of the more unsettled tax issues is that of the so-called “10/8” lever-aged loan insurance strategy. After more than two years of deliberations, these loans, which are backed by insurance policies, are still being scrutinized by the Canada Revenue Agency.

The central issue is whether 10/8 strategies allow policyholders to claim excessive interest expense deductions on their tax returns.

The CRA has not yet taken a formal stance on the 10/8 structure, but the agency apparently has softened its negative impressions of the product. The CRA continues to believe, however, that the 10% interest deduction will be problematic. It has launched a countrywide review of various aspects of the strategy and is awaiting the findings of that investigation before issuing a formal policy.

In the meantime, the insurance industry continues to maintain that its position on 10/8 vehicles is sound. Says Jorge Ramos, director of advanced marketing with Industrial Alliance Insurance and Financial Services Inc. in Toronto: “We’re trying to get the CRA to understand that we’re not trying to circumvent the tax rules but are working with them.”

For now, however, it’s a waiting game for insurance professionals. The CRA had indicated earlier this year that a policy decision on 10/8 would be announced within a couple of months, says Kevin Wark, senior vice president of business development with Toronto-based PPI Financial Group Inc., a specialized managing general agency focusing on high net-worth clients that sells 10/8 products.

But the CRA is still conducting due diligence on the product. According to Caitlin Workman, spokeswoman for the CRA in Ottawa, in an email: “The Canada Revenue Agency is currently examining the details, contracts, advisor opinion letters and money transfers with holders of ‘10/8’ insurance policies. Discussions are occurring throughout Canada related to excessive interest expense claimed by policyholders in their tax returns. These discussions will need to be completed before CRA will be able to discuss the issue publicly.”

These comments indicate that the CRA is not only concerned about excessive interest deductions but is also examining individual product features, the sales process and the use of loan proceeds.

This represents a shift from the CRA’s earlier stance, which zeroed in on concerns about high interest expense deductions. Evidently, the CRA is also trying to understand whether 10/8 guidelines are being implemented properly. Wark suggests that the CRA also wants to establish whether the borrowed funds are being used for income-producing purposes.

Wark notes the comments made by Wayne Adams, director general, income tax rulings, with the CRA, at the Canadian Tax Foundation’s 2008 meeting, during which Adams indicated that the CRA’s general anti-avoidance rule committee had reviewed a specific 10/8 product but could not give a “clean GAAR opinion” on whether policyholders were entitled to the 10% interest deduction.

Since then, Adams has reiterated concerns about the high interest deductions facilitated by the 10/8 strategy and has warned that taxpayers might find themselves before the CRA Appeals Branch or the Tax Court of Canada. More recently, however, he has been less critical about all 10/8 products, alluding to the fact that the particular product reviewed by the CRA in 2008 might not be representative of all products sold by other insurance firms.@page_break@This somewhat softer stance does not necessarily mean that 10/8 does not remain on the CRA’s radar screen but that some products might pass the agency’s smell test

So why is the 10/8 leveraged loan strategy under CRA scrutiny?

In simple terms, the strategy uses an insurance policy as collateral for a loan of up to 100% of the policy’s cash surrender value. The loan has a 10% interest rate and is made by the insurance company, a related entity or a third party, or by the underlying insurance policy. The loan interest rate is guaranteed for a period of 10 years or longer. The policy, typically a universal life policy, has an investment component which earns a guaranteed rate of return of 8%.

The policyholder then invests the borrowed money in an investment that is an “eligible” business investment as defined by the federal Income Tax Act — that is, in a business, property or other investment vehicle that has a “reasonable expectation” of earning income.

If the investment is eligible, the policyholder/taxpayer is able to deduct the interest on the loan as a business expense on his or her personal income tax return. The policyholder has to convince the CRA that the loan has been used for an eligible business purpose.

The big snag with the 10/8 strategy is that the CRA views the 10% interest deduction as being too high.

The rationale for using the 10/8 strategy is that the policyholder should eventually come out ahead. Together, the net effect of the investment and the loan is a loss of 2% (10% interest paid, less 8% income earned). However, if the policyholder has a marginal tax rate of 50% and the loan interest is tax-deductible, then the net benefit of the invested loan will be 3% (5% tax savings, less 2% net cost).

However, the policyholder could be further ahead if the borrowed funds are invested and earn a positive return of, say, 5%. In this case, the policyholder would make a return of 8% (3% after taxes, plus 5% on the invested loan).

As well, because the insurance policy is growing at a tax-deferred rate of 8%, the policyholder can receive additional loans secured by the growth in the cash value of the policy, providing further cash flow.

The policyholder does not necessarily have to repay the principal portion of the loan prior to death. If the accumulated cash remains in the policy until death, it can be added to the tax-free death benefit payable to the estate of the policyholder.

Evidently, the 10/8 strategy is indeed beneficial to policyholders.The insurance industry does not share the CRA’s view that a 10% loan interest rate is too high because of the long-term nature of the loans. Says Ramos: “We’re looking at long-term rates that are secured for at least 10 years.” The 10/8 strategy, adds Wark, “protects borrowers from potential spikes in interest rates.”

The insurance industry as a whole has been reviewing its forecasts of long-term interest rates, with a view to making the 10/8 program more palatable to the CRA. As a result, Industrial Alliance has come up with a “9/7” leveraged loan strategy, says Ramos. This product is “based on current forecast loan rates and has a more reasonable rate of return,” he says. “It is more palatable.”

To add credibility to the product, Ramos says that his company is using a third-party loan provider: “[10/8 and 9/7] loans are treated like any other third-party loans.”

There is no doubt that the CRA’s concern has raised uncertainty about the 10/8 product. Wark suggests that financial advisors “disclose to their clients that the CRA has expressed concerns about it.” IE