Introduction

The concept of using a life insurance policy with cash value as collateral security for a loan is not new. However, in recent years, this concept has evolved from future leverage (often at retirement) to one in which large sums of money are deposited into a life insurance contract, and then immediately accessed by way of a loan. This Tax Topic will examine the issues and tax implications to consider where an individual acquires an exempt life insurance policy with the intent of accessing the policy’s cash value by collaterally assigning the policy immediately or in the near future.

 What is it?

An Immediate Leveraged Life Insurance Arrangement (ILA) is an arrangement in which an individual or corporation purchases an exempt life insurance policy and deposits money into the policy in excess of what is needed to fund the insurance and policy charges. (The deposits usually equal the maximum permitted under the Income Tax Act). This has the effect of creating significant cash value.

The policy is then immediately (or in the near future) used as collateral security for a loan. Often the loan is structured as a demand line of credit with a floating interest rate. As such, the timing of the loan advances may be very flexible. The main limitation is that the outstanding loan cannot exceed a specified percentage of the cash surrender value of the life insurance contract. This percentage is often referred to as the “lending margin”. If desired, other assets may be assigned to provide additional collateral security to allow higher loan advances.

The borrowed funds are used to invest in a business or property that produces income. It is assumed that the policy owner can claim a tax deduction for the loan interest and a deduction for a portion of the insurance premiums paid, if applicable.

A collateral assignment of a policy is specifically excluded from the definition of “disposition” of a life insurance policy in subsection 148(9) of the Income Tax Act. This allows the policy’s cash value to continue to accumulate on a tax-deferred basis and therefore be used as a continuing source of collateral for bank loans to the policy holder.

The immediate leverage structure discussed in this Tax Topic has the following attributes: the loan is negotiated separately with the lender (not the insurance company) and the loan rate is determined independently from the insurance contract. There is no direct link between the contract of life insurance and the collateral loan agreement. The rate of return inside the policy is determined based on the contract and the policy performance.

If the insured dies while the loan is outstanding, the insurance proceeds repay the outstanding loan balance, and any excess amount is paid tax-free to the beneficiary named under the policy.

This arrangement requires three separate legal documents: a life insurance policy, a collateral assignment and a loan agreement.

Why Immediate Leverage?

The purpose of the structure is usually two-fold. First, it fulfils the need or desire for an estate benefit (i.e. life insurance). Secondly, it reduces the cash outflow needed to purchase this benefit. This is accomplished through a combination of tax-free growth in the policy, loan advances and tax savings from deductions. Immediate Leverage is an investment strategy; it allows the policy owner to get the insurance coverage they need while at the same time realizing the benefits of leveraged investing.

Who is it for?

Life insurance with immediate leverage is for healthy Canadian resident individuals who:

• need permanent life insurance protection
• are affluent and have steady cash flow exceeding their lifestyle requirements
• have significant amounts of taxable income subject to tax at a high rate,
• want to accumulate wealth in their corporation or through investments,
• are not adverse to debt (leverage) and have additional liquid assets available to help secure debt (if required),
• are receptive to long-term planning and investment strategies, and
• understand that there are tax and legal considerations which require consultation with a professional advisor.

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Life insurance characteristics

Any life insurance policy that has cash value can be used for immediate leverage. However, lenders often advance a higher margin on whole life policies (eg. 90%) than on universal life (UL) policies where the account value is invested in equity accounts. For example, on a whole life policy with $100,000 of cash value, the bank may allow a loan advance of $90,000, whereas on a UL policy with the same cash value invested in equity accounts, the bank may only allow a loan advance of $50,000. In addition, whole life policies tend to provide more stable long-term returns. This means that it is less likely for the cash value to fluctuate and therefore less likely for the loan to exceed the bank’s lending margin unexpectedly. As a result, typically whole life products with high cash values are used, but depending on the facts and circumstances, other policies may work as well.