I have said last year that the past is catching up with the insurance industry and that this industry must clean up its act. Before we discuss the implications of the new concept of a tax avoidance policy, it is necessary to understand why such a provision was deemed to be necessary.
There are two cultures in the insurance industry. There is a culture of cheaters who can’t sell the need for insurance and therefore resort to cheating and lying to sell insurance products either as an investment or a tax shelter. This culture has more than 40 years worth of history and started with the introduction of the single premium life insurance which forced the government to introduce amendments to the ITA under the form of the exemption test to outlaw this tax avoidance strategy.
However this did not discourage these cheaters. The more complicated the ITA became, the more resourceful and imaginative these cheaters became. It is also important to understand that the roots of this culture of cheating did not reside with the advisors. The roots of this culture resided in the many life insurance head offices .
With many gaps existing in the ITA regarding the taxation of life insurance, there were a lot of opportunities for abuses. Instead of being responsible where the insurance companies could have reached a consensus as to how to deal with these gaps, the cheaters walking the halls of these companies started to use these gaps in the ITA as marketing and competitive advantages over other insurance companies. This could therefore only go downhill as other companies were forced to match tax abuses against tax abuses in order to remain competitive.
As shown by the 10/8 strategy, the cheater’s culture was empowered by the willingness of the government to grandfather tax avoidance strategies. When I was working for these insurance companies how many times I cautioned my employer against abusing the ITA to be told not to worry because the government would protect these abuses by grandfathering them. And they were proven right. Many people like me refused to promote, support and sell the 10/8 strategy to clients. This meant saying no and losing hundreds of thousands of commission.
The people who used the 10/8 strategy in order to avoid paying taxes on income were right not to worry by believing the government would protect them. This is what happened when the government offered to pay the cost of their exit strategy out of this tax avoidance concept. Still today the government refuses to reveal the cost of getting these cheaters out of the 10/8 strategy. You also have to understand the recklessness of these cheaters. Unchecked the 10/8 strategy had the potential to bankrupt the Canadian government. It was not a question of if; it was a question of when. This is what the power of compounding interest deduction against income can do…
It was therefore not surprising that the Canadian government faced with an irresponsible industry willing to do anything in order to create sales decided to introduce this tax avoidance policy to close down any possibilities of future abuses. Normally the insurance industry would have strongly objected but the government picking up the tab to get people out of the 10/8 strategy became the price for their silence.
Still many people in the industry are angered by this. In the end, it is those who are honest and have not abused the system that are punished because now we are faced with a tax avoidance provision that specifically applies to insurance and can apply to any transactions made on life insurance.
What is the true purpose of this provision?
Considering that the tax avoidance provision 245(3) is broad enough to include insurance transactions does this mean this provision is redundant? Absolutely not. The purpose of this provision is other than tax avoidance.
1. This is an anti-grandfather provision. You have to remember that the insurers were successful in marketing their tax avoidance strategies by betting on the government history of grandfathering their abuses. By introducing the provision of a tax avoidance policy, the government has ended this practice. It will now be impossible for any future tax strategies created by the insurers to be grandfathered when they are considered as tax avoidance.
2. This provision shifts disclosure to the insurer and insurance agent. In the past, if a client had some reservations as to the legality of tax strategy created and promoted by an insurer; this client would be told to seek counsel with his lawyer or accountant because article 245(3) was a general tax provision. The tax avoidance policy is a life insurance provision and must be explained by the advisor in the same fashion that this advisor has to explain what is the ACB of a policy, the exempt test of a policy… Effectively, this tax avoidance policy provision will have the effect and impact of a cold shower on any sales that push the tax envelope.
3. This provision creates an ethical duty on the part of the advisor. Failure by the advisor to mention this provision or explain it adequately will create an ethical infraction on the part of the advisor.
4. This provision shifts liability to the insurer and advisor for any strategies involving insurance that could be considered tax avoidance. The tax avoidance policy provision will certainly make it easier for a client whose policy was deemed to be a tax avoidance policy to seek civil damages against the insurer and advisor.
Life transactions that will be impacted by this provision:
The tax avoidance policy target insurance transactions directly as listed in the explanatory notes in regards to the life insurance policy exemption test. This provision will also impact indirectly any transactions made on a life insurance policy since such transaction only have to reduce or increase the accumulating funds of the policy to potentially qualify as tax avoidance; as a result any transactions made on an insurance policy could trigger a 60 days’ notice from the government. Basically the burden of proof upon receipt of this notice will rest with the policy owner to explain and prove that the transaction was done for a valid purpose other than obtaining a tax benefit. Examples of such transactions are:
1. Overinflating the amount of insurance on a Universal Life with a YRT COI and then reducing and minimizing the amount of insurance to the ETP line will be an avoidance transaction. Also any changes to the face amount in order to reduce the COI and maximize the cash value is now potentially an avoidance transaction. Therefore such changes must be documented and the client and advisor must be ready to demonstrate that the initial face amount was justified and needed. This is truly the death of insurance as a tax sheltered investment. The consequences for the industry could be enormous because while the policy count for policies sold in this fashion may be low they represent at least 50% of the premium sold in the industry.
2. The cost of insurance of a Universal Life policy is usually deducted to age 100. However many insurance companies in order to circumvent the exemption test have decided to compress the Cost of insurance over 5, 10, or 20 years. There is no economic benefit for the client to prepay this cost of insurance since at death the client does not get back what he has prepaid. The only purpose of this transaction is to circumvent the ETP of a policy in order to be able to put more money in the policy in the early years. Any of these policies sold after 2015 would be an avoidance policy.
3. This provision will also impact other sort of policies indirectly such as multilife policies. By being able to add multiple insured under one policy, it is possible for one of the insured to borrow the ETP of the other insured (ETP is done at the policy level and is the sum of all the ETP of the different coverage). The notes state that: “the transaction will be an avoidance transaction unless it may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit of the policy being an exempt policy”. Again documentation will be critical to prove that the reason to put all of the insured under one policy was other than taking advantage of the increased exemption test. It’s even more important if the policy is divided afterwards tainting the transaction from a tax avoidance perspective.
4. The same would apply to a term rider on a life insurance policy. For example if a husband needs $500,000 of insurance and the wife needs $250,000 of term insurance. Instead of buying a separate term policy, the term coverage could be purchased as a rider. As a result, the exemption test instead of being applied to $500,000 of coverage only would be the sum of the ETP for the $500,000 and $250,000. This means the husband would be able to put a lot more premium in the early years of the policy. Is this an avoidance transaction? Difficult to say and it will be up to the courts based on the interpretation of the tax avoidance policy provision to decide what is an efficient transaction and what is an avoidance transaction. There are now risks with this strategy and this risk increases greatly if the policy is divided afterwards because of a divorce for example. Again documentation will be important but this is certainly not what a client will like to hear.
We now can see how the tax avoidance policy provision will change the sale of insurance. How does the advisor warn the client against this provision if he decides to buy a multilife policy or add a rider? It introduces an element of fear into transactions that I would have considered as being efficient from a tax perspective.
With this tax avoidance policy provision, we are seeing the end of the marketing of the Universal Life as an efficient tax shelter and also as a competitive investment. It never was anyway unless there was cheating involved. However this will have a great impact on the distribution of life insurance. This provision could reduce life sales by as much as 50%. Insurers will have no choice to focus their efforts back towards marketing need driven products which are much simpler in their nature. These products such as mortgage insurance are considered commodities. The good news is there is still a lot of potential growth in this market including term insurance, guaranteed wholelife and combo (critical illness/disability/insurance) products. Still the margins of these products are much lower than Universal Life and competition is getting more ferocious. Technology is now driving sales of these products but it is still undecided whether technology will enable clients to buy these products directly from the insurer or whether this technology will empower the advisor to showcase the value of his knowledge and advice.