Ottawa may soon tighten up on use of universal life as a tax shelterBy Alain Thériault | September 19 2013 07:52PM
The federal Department of Finance is holding industry consultations about the changes it intends to make to the tax rules governing life insurance policies. The tax-exempt status of universal life insurance could suffer as a result.After receiving comments during the first round of consultations in 2012, the federal Department of Finance is conducting a second round which will wind up on Nov. 6. In the wake of this consultation, the industry could see the federal tax authorities reduce the amount of investments that policyholders can hold tax-free inside of a life insurance policy over the long term.
Ottawa’s objective: to update the exemption test for life insurance policies applicable under the Income Tax Act. The government wants to dust off this test, which was last updated in 1982, and the tax law related to it.
Apart from the question of whether a policy is exempt or not, this consultation is also considering three other tax aspects that affect life insurance policyholders: which types of transactions result in the disposition of an interest in a policy, the tax treatment of this disposition, and modifications to the tax on investment income arising from other changes.
Policies issued before 2016 will be grandfathered.
The Canadian Life and Health Insurance Association (CLHIA) and the Conference for Advanced Life Underwriters (CALU) may be filing their submissions shortly as part of this consultation. The CLHIA seeks to understand the Finance Minister’s motivation behind certain proposals, explained Ron Sanderson, director, policyholder taxation and pensions at CLHIA, in an interview with The Insurance and Investment Journal. The CLHIA believes that as they now stand, some proposals will result in a higher degree of complexity and increased costs for insurers.
“Our concerns are that there may be a lot of technical behind the scene work that will result in significant costs for some life insurers that will be borne by policyholders, and there may not be a strong policy rationale for those changes,” says Sanderson. “The proposal is to calculate the exempt test at the coverage level instead of at the policy level. It brings a degree of details and complexity that may not add a lot of value to the consumer.”
The CLHIA also would like to have some clarification, for example with regard to anti-avoidance proposals. “There is a specific proposal that says in essence that if CRA looks how a policy is used and doesn’t like it, then it can assess under an AAR and essentially have the policy treated as a non-exempt policy. But it’s not clear what the trigger would be for the CRA to take that interpretation, and the rule appears to be much less well defined than the general AAR in the Tax Act. Does this specific AAR make sense given that a general AAR already exists and is much better defined?” questions Sanderson.
For its part, CALU is working with the CLHIA and the Department of Finance to understand the impact of the proposed changes, which will be effective for policies. “Our primary concern is to ensure there are no unintended impacts on policyholders as well as the fair tax treatment of different types of insurance policies currently available in the marketplace,” comments Wark.
PPI, a managing general agency, has several advisors who are members of CALU, and it is also analyzing Ottawa’s consultation documents. PPI will not be submitting comments but its chief actuary, John McKay, will participate in CALU’s discussion. When contacted by The Insurance and Investment Journal, he said that he would rather not comment.
André Cyr, an advisor specializing in the type of customer most likely to be affected by the proposed changes, is associated with PPI and is also a member of CALU. He is not overly concerned by the changes announced by Ottawa, and says he is confident that CALU and CHLIA will band together to make certain the government’s changes do not result in adverse effects for policyholders.
Instead, Cyr sees this consultation as an opportunity to update current practices. “From what I understand, the exempt test may now be based on the value of the accumulated funds rather than the cash value,” he commented in an interview with The Insurance and Investment Journal. In his opinion, this focus on the net value of the accumulated funds will favour level cost of insurance (COI) policies, a type of universal product he considers ideal for savings.
Cyr has just under 200 customers whose average amount of insurance coverage is $10 million, and many of these customers have universal life not only for protection, but also for wealth accumulation. He has consistently offered level cost of insurance universal life policies, which are better able to protect accumulated funds than those in which the cost of insurance increases annually. The latter type of policies eat away at the accumulated funds over time, he says, especially when the insured person reaches an advanced age.
Cyr does not believe the situation is going to improve as the insured population lives longer and longer. “We see more and more insured people who are older than 90,” he comments.
What about the problem of level COI universal life that has been sold based on paying the minimum premium (and with almost no accumulated savings)? Cyr does not sell it. “We do not sell universal life based on the minimum premium,” he says. “Universal life is made to accumulate funds. If you are not filling it, why have one? It must be sold with a premium payable over 5 years or 10 years and the money has to go into investment funds. The goal is to have it pay for itself as soon as possible.”
Finally, he believes that by applying the exemption test to the fund value rather than the surrender value, the federal tax authorities intention is to curb certain “cowboy” practices in which some insurers have agreements with advisors to keep the cash surrender value at zero during the initial years during which the test applies. Then suddenly they have the cash value appear, once the policy is sufficiently exempt.
“I have never dealt in that area. In any case, a well structured policy will eventually become exempt even if the initial deposit exceeds the limits,” explains Cyr. As an example, he takes a customer who deposits a $3.5 million premium into a level cost of insurance universal life policy in the first year (the policy has a face value of $10 million). Under the exempt test, he can accumulate $600,000 tax-free per year. As a result, there will still be $2.9 million that is not exempt from tax in the policy’s side fund in the first year of coverage. The following year, the burden will be reduced another $600,000 and so on. Over the years, the policy will become completely exempt.
Customers buy this kind of concept even if there is tax to pay, comments Cyr. “In any case, the insured’s savings would not do better in his bank account, where they would also be taxed.”