Collateral Loans Against Life Insurance Cash Value in Canada

Introduction

A collateral loan against a life insurance policy involves borrowing from a third party lender, usually a bank, with the policy assigned to that lender as security.

It is the mechanism that sits underneath most Canadian planning built around accessing the cash value of a permanent policy during life, including arrangements marketed as insured retirement plans and as infinite banking.

The reason it appears so frequently is a single provision in the definition of disposition. Understanding that provision, and the limits around it, is what separates a defensible arrangement from one that produces an unexpected tax bill.

Why the Assignment Is Not a Disposition

Subsection 148(9) of the Income Tax Act defines disposition broadly for life insurance purposes. It includes a surrender, a policy loan made after March 31, 1978, and the dissolution of the interest on maturity.

It then sets out exclusions. The first of these is an assignment of all or any part of an interest in the policy for the purpose of securing a debt or a loan other than a policy loan.

Because a collateral assignment falls within that exclusion, no disposition occurs when the policy is assigned. No proceeds arise, and subsection 148(1) is not engaged.

The contrast with a policy loan is stark. A policy loan is expressly included in the definition of disposition and can produce a fully taxable policy gain. A collateral assignment produces nothing at the time it is made.

The adjusted cost basis is also unaffected by the assignment itself, which preserves the position for later transactions.

What the Arrangement Looks Like

The structure generally follows the same pattern.

The policy owner holds a permanent policy with accumulated cash value. A lender agrees to advance funds, secured by an assignment of the policy.

The lender advances a percentage of the cash surrender value rather than the full amount, with the loan to value limit depending on the lender and on the investment options within the policy.

Interest accrues. Depending on the arrangement, the owner may service the interest or allow it to capitalize against the loan.

On death, the death benefit is applied to repay the outstanding loan, with any remainder going to the beneficiary or to the corporation.

Interest Deductibility

Interest deductibility turns on paragraph 20(1)(c), and the test is the use of the borrowed money, not the source of it or the security given.

Paragraph 20(1)(c) permits a deduction for interest on borrowed money used for the purpose of earning income from a business or property.

There is an important carve out within that provision. It expressly excludes borrowed money used to acquire a life insurance policy. Interest on funds borrowed to buy the policy in the first place is therefore not deductible under this paragraph.

Borrowing against an existing policy and investing the proceeds in an income earning business or property is a different matter, and in that case the ordinary interest deductibility analysis applies.

Borrowing against the policy to fund personal consumption produces no deduction. This is worth stating plainly, because arrangements are frequently illustrated on the assumption that interest will be deductible without confirming how the funds will actually be used.

The Premium Deduction Under Paragraph 20(1)(e.2)

A separate and narrower deduction may be available for a portion of the premiums themselves.

Paragraph 20(1)(e.2) permits a deduction equal to the least of three amounts in respect of a life insurance policy, other than an annuity contract or an LIA policy.

The first amount is the premiums payable by the taxpayer under the policy in respect of the year, but only where three conditions are all met. An interest in the policy must be assigned to a restricted financial institution in the course of a borrowing from that institution. The interest payable on the borrowing must be deductible, or would be deductible but for certain specified provisions. And the assignment must be required by the institution as collateral for the borrowing.

The second amount is the net cost of pure insurance for the year, as determined in accordance with the regulations, in respect of the assigned interest. Periods after 2013 during which the policy is a 10/8 policy are excluded.

The third amount is the portion of the lesser of the first two that can reasonably be considered to relate to the amount owing from time to time during the year under the borrowing.

Three points follow from this structure.

The deduction is capped at net cost of pure insurance, which in early policy years is a small figure relative to premiums paid. Owners expecting to deduct their full premium will be disappointed.

The lender must be a restricted financial institution, and the assignment must be required by that institution. An assignment given voluntarily, or to a lender outside that category, does not qualify.

The deduction is proportionate to the amount actually owing, so a policy assigned against a small loan supports only a small deduction.

Capitalized Interest

Where interest is not serviced in cash and instead accumulates, the loan balance grows over time.

This has no immediate tax consequence on a third party collateral loan in the way it does on a policy loan, but it has a practical one. The loan balance compounds while the cash surrender value grows at its own rate.

Where the loan balance approaches the lender’s limit relative to the policy value, the lender may require repayment or additional security. This is the point at which these arrangements most often fail.

Treatment at Death

On death, the outstanding loan is repaid from the death benefit.

For a corporate owned policy, the capital dividend account credit under paragraph 89(1)(d) is the proceeds less the adjusted cost basis of the policy.

The CRA historically took the position that the credit was denied where proceeds were paid directly to the creditor as beneficiary or where the creditor held an absolute assignment. That position was tested in the courts and did not prevail in the circumstances considered there.

The structure of the assignment matters to this analysis. A collateral assignment and an absolute assignment are different things, and the documentation should be reviewed rather than assumed.

The 10/8 Restrictions

The 2013 federal budget targeted a particular class of leveraged arrangement, defined in subsection 248(1) as a 10/8 policy.

Where a policy falls within that definition, subsection 20(2.01) provides that interest does not include amounts paid or payable in respect of a period after 2013 during which the policy is a 10/8 policy, which removes the interest deduction.

Paragraph 20(1)(e.2) separately excludes those periods from the net cost of pure insurance component, removing the premium deduction. The capital dividend account credit is also restricted.

Ordinary collateral lending was not eliminated by these measures. The rules target arrangements with the specific features set out in the definition, principally borrowing from the same insurer that issued the policy on terms within a specified range.

The Risks That Are Not Tax Risks

The tax analysis is only part of the picture, and the non-tax risks are what actually unwind these arrangements.

The lender can change its terms, reduce its lending limits, or decline to continue advancing. Arrangements projected over thirty years depend on lending conditions over that entire period.

Interest rates move. An arrangement that works at one rate may not work at a materially higher one, particularly where interest is capitalizing.

The policy’s performance is not guaranteed. Dividend scales are declared annually at the insurer’s discretion, and projections showing steadily rising values rest on assumptions.

If the loan cannot be serviced and the policy must be surrendered to repay it, the surrender is a disposition, and the taxable policy gain arrives at precisely the moment the owner has the least capacity to pay it.

Common Planning Mistakes

Several errors recur.

Assuming interest is deductible because the loan is secured by a policy, without regard to how the borrowed funds were used.

Expecting to deduct full premiums under paragraph 20(1)(e.2) rather than an amount capped at net cost of pure insurance and prorated to the loan balance.

Failing to confirm that the lender is a restricted financial institution and that the assignment is required by the lender.

Allowing interest to capitalize without monitoring the loan balance against the lender’s limit.

Treating a collateral loan and a policy loan as interchangeable when comparing illustrations.

Conclusion

A collateral assignment of a life insurance policy to secure a third party loan is expressly excluded from the definition of disposition in subsection 148(9), so no policy gain arises at the time of borrowing. This is the structural basis for most leveraged insurance planning in Canada.

Interest deductibility is governed by paragraph 20(1)(c) and depends on the use of the borrowed funds. That paragraph expressly excludes borrowed money used to acquire a life insurance policy.

Paragraph 20(1)(e.2) may permit a deduction for part of the premiums, but only where the policy is assigned to a restricted financial institution that requires the assignment, the related interest is deductible, and then only up to the net cost of pure insurance prorated to the amount owing.

Where a policy is a 10/8 policy as defined, both the interest deduction and the premium deduction are denied for periods after 2013.

The arrangement should be stress tested against higher interest rates, lower dividend scales and changes in lending terms before it is entered into, because the tax treatment is the part that is most predictable.

Tax Partners can assist you in structuring your affairs properly and ensuring full compliance while optimizing your tax position.

This article is written for educational purposes.
 

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