Infinite Banking in Canada: What It Is and How It Is Taxed

Introduction

Infinite banking is one of the most heavily marketed financial strategies in Canada, and one of the least precisely described.

The term covers an arrangement in which a policy owner uses the cash value of a permanent life insurance policy as a personal or business source of financing, rather than borrowing from a conventional lender each time capital is needed.

It is worth stating plainly at the outset what infinite banking is not. It is not a product, an account, or a financial instrument. No insurer in Canada issues an infinite banking policy.

The underlying transaction is the purchase of a participating whole life insurance policy. Everything described as infinite banking is a way of using that policy. Understanding the arrangement in those terms is the first step to evaluating whether it makes sense.

Where the Concept Comes From

The concept originated in the United States and was popularized there beginning in the 1980s. It has since been adapted and marketed in Canada under a range of names, including the infinite banking concept, becoming your own banker, and various proprietary labels used by individual advisors.

The Canadian versions operate under Canadian tax law, which differs from the American rules in important respects. Material written for a United States audience should not be relied on for Canadian planning.

How the Arrangement Works

The structure generally follows the same sequence.

The policy owner purchases a participating whole life policy, frequently with an additional deposit or paid-up additions rider that directs more of each payment toward cash value rather than base coverage.

The policy is funded at or near the maximum level permitted by the exempt test rules, often over a compressed period of several years.

Cash value accumulates inside the policy. Growth is not subject to annual accrual taxation while the policy remains exempt.

When capital is required, the owner accesses the cash value rather than borrowing elsewhere, then repays over time so the value is available again for future needs.

The Two Ways to Access the Value

This is the part of the arrangement where the tax consequences actually sit, and where the marketing is frequently imprecise.

A policy loan is an advance from the insurer under the terms of the contract. The definition of disposition in subsection 148(9) of the Income Tax Act expressly includes a policy loan made after March 31, 1978.

Because it is a disposition, subsection 148(1) applies. A taxable policy gain arises where the proceeds exceed the adjusted cost basis of the interest. That gain is included in income in full as ordinary income.

A collateral loan is different. The owner borrows from a third party lender, typically a bank, and assigns the policy as security. The definition of disposition specifically excludes an assignment of an interest for the purpose of securing a debt or loan other than a policy loan.

No policy gain arises on a collateral arrangement at the time of borrowing. This is the mechanism that makes the tax outcome described in most infinite banking marketing possible.

The two routes are frequently presented interchangeably. They are not interchangeable, and the difference can be material.

Interest and Premium Deductibility

Two separate deduction questions arise, and they are often conflated.

Interest on borrowed money may be deductible under paragraph 20(1)(c) where the funds are used for the purpose of earning income from a business or property. This depends entirely on the use of the borrowed funds, not on the source of the borrowing. Borrowing against a policy to fund personal consumption produces no deduction.

Premiums are a separate matter. Life insurance premiums are generally not deductible. A narrow exception exists under paragraph 20(1)(e.2) where a policy is assigned as collateral for a loan from a restricted financial institution and specific conditions are met, and the deductible amount is limited.

Neither deduction should be assumed. Both depend on facts that need to be established and documented.

What the Marketing Tends to Omit

Several features of the arrangement rarely appear in promotional material.

Cash value in the early years is typically well below cumulative premiums paid. The arrangement generally requires a holding period measured in decades before the accumulated value meaningfully exceeds what was contributed.

The exempt test rules cap how much can be funded into the policy on a tax advantaged basis, and the revisions effective January 1, 2017 reduced the longer term room available.

Policy dividends are declared annually at the discretion of the insurer and are not guaranteed. Illustrations showing decades of growth rest on a projected dividend scale that will not be matched exactly.

Where the policy is accessed through a collateral loan, the arrangement depends on a lender continuing to lend on acceptable terms. Lending conditions, interest rates and the lender’s appetite can all change over a thirty year horizon.

The commitment is long and relatively illiquid. Surrendering the policy early generally produces a poor financial result and may produce a taxable policy gain at the same time.

The Corporate Dimension

Where the policy is owned by a corporation rather than personally, additional considerations apply.

Premiums are funded with corporate dollars, which is often more efficient than extracting funds personally first. On death, the proceeds less the adjusted cost basis generate a capital dividend account credit that can support a tax free capital dividend.

However, a corporate owned policy used to fund personal borrowing raises shareholder benefit exposure under subsection 15(1). The arrangement needs to be structured so that the benefit of the corporate asset is not conferred on the shareholder personally without consideration.

Moving a policy out of the corporation later is itself a taxable disposition governed by subsection 148(7), with no rollover available.

These are not reasons to avoid corporate ownership. They are reasons to decide on ownership structure before the policy is issued rather than afterward.

Who the Arrangement Suits

The strategy is most defensible where several conditions hold together.

There is a genuine long term need for permanent life insurance, independent of the financing feature.

There is stable surplus cash flow available after registered plan room has been used, since registered accounts generally offer simpler tax advantaged accumulation.

The owner is comfortable with a multi decade commitment 

and limited early liquidity.

Professional tax advice is in place, particularly where a corporation is involved.

Where the first condition is absent, the arrangement is difficult to justify. A person with no permanent insurance need who is sold a policy as a savings vehicle has purchased insurance costs they did not require.

Common Planning Mistakes

Several errors recur.

The most common is treating policy loans and collateral loans as the same thing, and discovering the tax consequence of a policy loan after the fact.

Another is assuming interest is deductible because the borrowing is secured by a policy, without regard to how the funds were used.

A third is relying on illustrated values as though they were contractual, rather than stress testing them against lower dividend scales.

Finally, some owners enter the arrangement through a corporation without addressing shareholder benefit exposure or planning for eventual ownership of the policy.

Conclusion

Infinite banking describes a method of using a participating whole life insurance policy as a source of financing. It is not a product, and the underlying transaction is a life insurance purchase.

The tax treatment depends on how the cash value is accessed. A policy loan is a disposition under subsection 148(9) and can produce a fully taxable policy gain. An assignment of the policy as collateral for a third party loan is expressly excluded from that definition and does not.

Interest deductibility depends on the use of the borrowed funds under paragraph 20(1)(c), and premium deductibility is limited to the narrow circumstances in paragraph 20(1)(e.2).

The arrangement can work where there is a genuine permanent insurance need, stable surplus cash flow, a long time horizon, and proper structuring. It works poorly where any of those are missing.

Anyone evaluating it should assess the insurance purchase on its own merits first, and the financing feature second.

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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