CRA rebuked for “fishing expedition”

It also appears that the decision may have weakened the CRA’s case against 10/8s in general. During the court proceedings, the CRA was forced by the court to produce some documents of its own — material revealing that the CRA, apparently in conflict with some of its public statements, believes that 10/8 products probably conform with the formal requirements of the Income Tax Act, if not its spirit.

 The CRA could still challenge 10/8 arrangements on a case-by-case basis if it finds the facts of any particular arrangement to be abusive, says Sanderson: “The question now is: does the CRA have an organized way of going out and looking for 10/8 arrangements, or will it have to address them as it finds them through audits of individual taxpayers? I suspect [the CRA] will be left with the latter.”

A typical 10/8 leveraged-loan strategy involves an individual buying an insurance policy and then obtaining a loan of up to 100% of the cash-surrender value of the policy. The loan is secured by the policy. In most 10/8 scenarios, the insurer and the lender are the same or are related firms.

In a typical 10/8 scenario, the investment portion of the policy earns an annual rate of interest, set at 8%. The taxpayer then pays interest on the loan at 10%. The 8% interest earned by the policyholder is tax-exempt as part of the investment portion of the policy, while the 10% interest payable on the loan is tax-deductible if the funds are used to earn investment income. In exchange for paying an effective interest rate of 2% (the insurer’s profit), the taxpayer receives both a needed life insurance policy and a significant tax deduction (the 10%), creating a tax-efficient leveraging strategy.

 The main 10/8 feature under attack by the CRA has been the level of the interest rates, which is the essence of what makes these arrangements attractive to clients looking for tax relief on their investments. Most 10/8s are sold to high net-worth individuals.

Over the past few years, the CRA has suggested that 10/8 arrangements could be abusive under the ITA’s general anti-avoidance rule. However, the CRA has stopped short of clearly explaining which elements of 10/8 arrangements it felt were problematic. Leaders within the insurance industry have said that the lingering uncertainty about whether the 10/8 scenario could survive GAAR has created a chilling influence on the sale of these loans.

Between late 2009 and the first half of 2010, the CRA had asked the Federal Court to require that four insurers — RBC Life Insurance Co. of Mississauga, Ont., BMO Life Assurance Co. of Toronto, Vancouver-based Industrial Alliance Pacific Insurance and Financial Services Inc. and Industrielle Alliance Assurance et Services Financiers Inc. of Quebec City — divulge information, such as the names, social insurance numbers and other identifying information, related to clients who own 10/8 products. The court issued an ex parte order — a judge’s decision made without the involvement of all parties — to each of the insurers to produce that information. While the insurers did give the CRA some information regarding 10/8s, they refused to divulge client names and other identifying details. Each firm challenged the court’s order.

As a result, the Federal Court asked the CRA to produce internal documents and memos related to 10/8s. At first, the CRA refused to turn over those documents, saying they were privileged or irrelevant, but the agency eventually relented.

The documents weakened the CRA’s argument that it needed the names and information of 10/8 clients for audits. Among other things, the court learned that a CRA committee had concluded that 10/8s comply with the formal requirements of the ITA, if not necessarily with its intent, and that it would be difficult to use GAAR to challenge 10/8s.

The CRA documents also revealed that the CRA had referred the matter of 10/8s to the Department of Finance, but Finance had chosen not to address the CRA’s concerns over 10/8 products through legislation.

Perhaps the most damaging revelation was an internal e-mail that reveals that a specialist within the CRA felt that “a limited number of targeted audits will be extremely effective in putting the [insurance] industry on notice that CRA is concerned about the direction they’re headed [with 10/8s].”

The Federal Court, in reaching its decision to reverse its previous ex parte orders for client names, found that the CRA had failed to make full and frank disclosure in its ex parte application. The court also suggested that the primary purpose of the request for information appeared to be to send a chill through the insurance industry.

“I am satisfied that this [internal CRA] information was material,” wrote Justice Danièle Tremblay-Lamer in the decision. “And that, because of its omission from the ex parte applications, the court was not in a position to make an informed decision.”

The CRA, which has until Dec. 1 to appeal, says it is reviewing the decision but declines to comment on the matter.

Tax specialists say the insurance industry may now be on stronger footing with 10/8 products. “The CRA has admitted in these documents that 10/8s work technically,” says Jamie Golombek, managing director, tax and estate planning, with Canadian Imperial Bank of Commerce’s private wealth-management division in Toronto. “So, I think the industry would feel more comfortable about the strategy.”

Of course, it is possible that Finance will decide to weigh in on 10/8s at some point, Golombek adds: “We have to wait and see whether Finance issues a comment, announces legislation or just stays out of it.”             IE