CRA Audit Risk With Infinite Banking Strategies in Canada

Introduction

Holding a permanent life insurance policy and borrowing against it is not aggressive tax planning. The treatment of both the policy and the borrowing is set out plainly in the legislation, and nothing about the arrangement is novel.

So the honest starting point is that infinite banking is not itself a red flag. Policy owners who have been told otherwise, in either direction, have been told something inaccurate.

What does attract attention are specific elements that often accompany these arrangements, particularly deductions claimed and benefits conferred. The exposure is almost always in the execution rather than in the concept.

The History Worth Knowing

Leveraged insurance arrangements have a track record that informs how they are viewed.

Two structures in particular were eliminated by legislation more than a decade ago, after a period in which the Canada Revenue Agency had been scrutinising them without consistent success in the courts. Both involved borrowing arrangements layered onto policies to generate deductions.

The legislative response removed those deductions and restricted the related corporate distribution credit. In one case, existing arrangements were not grandfathered.

The relevance today is twofold. Arrangements with those specific features are no longer viable, and occasionally resurface in modified form. And the episode demonstrates that where leveraged insurance arrangements are seen to produce results the system did not intend, the response has been legislative rather than merely administrative.

Ordinary collateral lending against a policy was not affected and remains available.

Where the Actual Exposure Sits

The areas that generate assessments are consistent:

• Interest deductions claimed without the borrowed funds being traceable to an income earning use
• Premium deductions claimed where the narrow conditions permitting them are not met
• Shareholder benefits arising where corporate policy value supports personal borrowing
• Corporate distribution credits calculated on amounts larger than the structure actually supports
• Arrangements carrying the specific features of the structures eliminated by legislation

None of these is about the policy. Each is about a claim made or a benefit conferred alongside it.

Interest Deductions and Tracing

This is the most common exposure by a considerable margin.

Interest is deductible where the borrowed money is used to earn income from a business or property. The test looks at what the funds were actually used for, not at what secured the borrowing.

An investor who borrows against a policy and acquires a rental property is in a sound position, provided the connection between the borrowing and the acquisition can be demonstrated.

An owner who borrows against a policy, deposits the funds into a general account, and uses that account for a mixture of personal and investment purposes has a tracing problem. The deduction may be reduced or denied not because the use was improper but because the connection cannot be established.

The remedy is procedural rather than clever. Borrowed funds should be kept separate, the use documented at the time, and the records retained. This is straightforward to do in advance and close to impossible to reconstruct afterward.

Premium Deductions

Premiums are generally not deductible, and a narrow exception exists where a policy is assigned as collateral to a particular category of lender that requires the assignment.

Even where it applies, the deductible amount is capped at the annual charge for the cost of the coverage, and is further limited to the portion relating to the amount actually owing.

Claims in this area go wrong in predictable ways. The lender does not fall within the required category. The assignment was given voluntarily rather than required. The full premium is claimed rather than the capped amount. Or the proportionate limitation is ignored.

Because the conditions are specific and the amount is formulaic, these claims are relatively easy to test, which makes them a poor place to be approximate.

Shareholder Benefits in Corporate Arrangements

Where the policy is owned by a corporation, this is the most significant exposure and the one most frequently overlooked.

Corporate policy value supporting a shareholder’s personal borrowing means the corporation has provided something of value and received nothing in return. The value conferred can be included in the shareholder’s income, with no deduction available to the corporation.

The arrangement is not improper. It simply requires the corporation to be compensated on commercial terms and the arrangement to be documented when it is put in place.

An arrangement that has operated for several years without being examined has not been accepted. It has not yet been looked at, which is a different thing.

Valuation Questions

Where a policy is transferred between parties, its fair market value becomes relevant and is frequently contested.

Value for this purpose is not the cash surrender value. It reflects the health of the insured, the guarantees in the contract, and the cost of obtaining equivalent coverage, among other factors.

An amount determined informally, or by someone with an interest in the outcome, is unlikely to withstand scrutiny where the figure is material.

An independent actuarial valuation prepared at the time of the transfer is the appropriate step. Obtaining one afterward, when the position is already under examination, carries considerably less weight.

What Documentation Should Exist

For most arrangements, the file should contain a consistent set of records.

The reason the insurance was purchased, recorded at the time, particularly where there is a business purpose such as funding a buy-sell arrangement or protecting against the loss of a key person.

Evidence of the use of any borrowed funds, traceable from the advance to the expenditure.

Corporate resolutions covering any arrangement under which the corporation provides value to a shareholder, together with the terms on which the corporation is compensated.

Confirmation from the insurer of the policy’s cost basis at the relevant dates.

Independent valuations where a policy has been transferred.

None of this is burdensome to assemble as the arrangement proceeds. All of it is difficult to produce years later.

The Role of the Advisor

A practical observation about how these arrangements come to be structured poorly.

They are usually designed by someone licensed to sell insurance rather than by someone responsible for the tax filings. The design is frequently sound as insurance and incomplete as tax planning, because the deductions and benefits were not the designer’s area.

The illustrations supporting these arrangements often assume favourable treatment of interest and premiums without confirming that the conditions are met.

Having the structure reviewed by the person who will sign the returns, before the policy is issued rather than afterward, resolves most of this. The cost of that review is small relative to the exposure it prevents.

Common Planning Mistakes

Several errors recur.

Depositing borrowed funds into a general account, which destroys the ability to trace the use.

Claiming full premium deductions where only a capped and prorated amount is available.

Using corporate policy value for personal purposes without consideration or documentation.

Relying on an informal valuation on a transfer where the amount is material.

Treating the absence of a prior review as confirmation that the arrangement is sound.

Conclusion

Holding a policy and borrowing against it is ordinary, and the arrangement is not itself a source of exposure.

The exposure sits in the claims and benefits that accompany it, principally interest deductions where the use of funds cannot be traced, premium deductions beyond the narrow circumstances and capped amount permitted, and shareholder benefits where corporate value supports personal borrowing.

Arrangements with the particular features of the leveraged structures eliminated by legislation a decade ago remain unviable and occasionally resurface in modified form.

Documentation created as the arrangement proceeds resolves most of this, and documentation attempted afterward rarely does.

The structure should be reviewed by whoever is responsible for the tax filings before the policy is issued, not when a question arises.

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.
 

Should you have any inquiries, please do not hesitate to contact us at (905) 836-8755, via email at info@taxpartners.ca, or by visiting our website at www.taxpartners.ca.
 

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