The 10/8 Arrangement and the Leveraged Insured Annuity, and Why They Ended

Two arrangements built on borrowing against a life insurance contract were ended by Parliament in 2013, and the provisions that ended them are still in the Income Tax Act, still in force, and still the first thing a careful adviser reads before any leveraged arrangement is assembled. This page explains what a 10/8 policy and an LIA policy were, which provisions answer each, and what an arrangement today must look like to stay outside those definitions. It does not explain the current immediate financing arrangement, which has its own page, and it does not repeat which part of the premium is deductible, which has its own page too.

Everything below is general information written by a licensed insurance professional, and it describes mechanism rather than giving advice. Whether a particular contract, borrowing or corporate structure is caught by any provision named here is a question for a Chartered Professional Accountant reading the actual documents. Canadian Wealth Creation Centre Inc., trading as IBC Financial, is not authorized to give legal, tax or notarial advice and gives none here.

What was a 10/8 arrangement?

A life insurance contract sold together with a loan against it, where the return credited to an account inside the contract was set by reference to the rate charged on the loan. The name records the two rates most often used, 10 percent charged and 8 percent credited, and the 8 percent existed only because the loan did.

The contract was usually a universal life contract with a dedicated account, and the lender was often the insurer itself or a lender working with it. The holder borrowed a large sum against the contract, paid interest at the higher rate, and a matching amount sat in the account earning the lower rate. Read as arithmetic and nothing more: on 100 borrowed, 10 was paid in interest and 8 was credited to the account, a cost of 2 before tax.

The tax results were what made that arithmetic attractive. The interest was claimed as a deduction on the footing that the borrowed money was used to earn income. The 8 credited inside the contract accumulated without annual taxation, because the contract met the exempt test. Where a corporation held the contract, the death benefit, including the account, could be credited to the capital dividend account and paid out to shareholders without tax, while the loan was repaid out of that same death benefit.

So a cost of 2 before tax became, after the deduction of 10 at corporate or personal rates, a positive result for the holder, funded by a credited return that would not have been paid at all if the loan had not been taken. The Income Tax Act names that exact feature today in the definition of a 10/8 policy in subsection 248(1), and the definition is where the rest of this page starts.

What was a leveraged insured annuity?

A pairing of two contracts on the same life, a life annuity and a life insurance contract, with a borrowing secured by an assignment of both. The annuity payments serviced the interest and the premium, the death benefit repaid the loan, and the borrower claimed deductions along the way. Today the Act calls the caught contract an LIA policy.

The mechanics ran in a circle that was easy to describe and hard to fault under the rules of the time. A holder, often a corporation, bought a life annuity on an individual and a life insurance contract on the same individual. A lender advanced funds against both, and the annuity payments, which were partly a return of the capital paid for the annuity, covered the interest on the loan and the premium on the contract. On the death of the individual, the death benefit paid off the loan and the annuity stopped.

Three tax results made the circle worth assembling. The interest was deducted as borrowed money used to earn income. Part of the premium was deducted as the cost of a contract assigned as collateral for the borrowing. And at the individual's death, the annuity, which had been bought for a large sum, was worth very little for the purposes of the deemed disposition, because its payments were about to stop, while the death benefit could be credited to a corporation's capital dividend account in full.

The difference from the 10/8 arrangement is worth stating plainly. The 10/8 manufactured a credited return that depended on the loan. The leveraged insured annuity manufactured nothing; it combined three ordinary rules, on interest, on collateral premiums and on the valuation of an annuity at death, so that they offset one another. Parliament answered with two definitions and two sets of consequences, which is why this page treats them separately.

Why did Parliament end them?

Because each arrangement produced a deduction and a sheltered accumulation that cancelled one another out and left a net tax benefit with almost no economic substance underneath it. The provisions that answer them date from 2013, apply to taxation years ending after March 20, 2013, and were written narrowly enough to leave ordinary borrowing against a contract untouched.

The objection to the 10/8 was that the return being sheltered was not a return in any ordinary sense. It was credited only because the loan existed and at a rate chosen by reference to the loan. A taxpayer who deducts interest paid to a lender in order to be credited a smaller amount by that lender's insurance arm is not earning income from property; the arrangement was the deduction, dressed as a contract. The definition in subsection 248(1) describes that dependency in two forms, and the consequences attach to the definition rather than to any product name.

The objection to the leveraged insured annuity was different, and it was about valuation. An annuity bought for a large sum and worth almost nothing at death, sitting beside a death benefit worth the whole loan, meant that the deemed disposition at death under subsection 70(5) caught almost none of the capital that had gone into the arrangement, while the capital dividend account caught all of the death benefit. Subsection 70(5.31) now fixes the value of that annuity at death, and the other consequence provisions remove the rest.

None of this was a prohibition. The Income Tax Act does not forbid a person from borrowing against a contract, from owning an annuity, or from assigning either as security. What it does is remove the results that made these two arrangements worth assembling, so that a person who assembles one today carries all of the interest, all of the lender's terms and all of the contract's own costs, with none of the offsets.

What does the Act do today to a 10/8 policy?

Three things. Subsection 20(2.01) says the interest on the borrowing is not interest for the purpose of the deduction. Paragraph 20(1)(e.2) withholds the premium deduction while the policy is a 10/8 policy. And the capital dividend account definition in subsection 89(1) reduces the credit at death by the loan outstanding.

The definition comes first, because everything else hangs on it. A 10/8 policy under subsection 248(1) is a life insurance policy, other than an annuity, where an amount is or may become payable under the terms of a borrowing to a person who has been assigned an interest in the policy or in an account the Act calls an investment account in respect of the policy, or under a policy loan made under the policy's own terms; and where either the return credited to that account is determined by reference to the rate of interest on the borrowing and would not be credited if the borrowing did not exist, or the maximum amount of the account is determined by reference to the amount of the borrowing. Both branches describe an account whose existence or size depends on the loan.

Subsection 20(2.01) then removes the interest deduction. For the purposes of paragraphs 20(1)(c) and 20(1)(d), interest does not include an amount paid after March 20, 2013, in respect of a period after 2013, in respect of a life insurance policy that is a 10/8 policy at the time of the payment, nor an amount payable in respect of a period after 2013 during which the policy is a 10/8 policy, where the amount is the one described in paragraph (a) of the definition. The words are precise: the deduction is not reduced or capped, it is denied, because the amount is deemed not to be interest at all.

Paragraph 20(1)(e.2) works on the premium. Its subparagraph (ii), which sets the net cost of pure insurance as one of the three amounts the deduction cannot exceed, excludes any period after 2013 during which the policy is a 10/8 policy. With that amount at zero, the least of the three amounts is zero, and the premium deduction goes with the interest deduction. What the paragraph allows for a contract that is not caught is explained on its own page and is not repeated here.

The third consequence reaches the corporation at death. Paragraph (d) of the definition of capital dividend account in subsection 89(1) adds the proceeds of a life insurance policy received in consequence of a death, and its subparagraph (iv) then subtracts, where the policy is a 10/8 policy immediately before the death and the death occurs after 2013, the amount outstanding immediately before the death of the borrowing described in the definition. The death benefit still arrives and still repays the lender; what does not arrive is the tax-free credit for the part of it that was only ever the loan. How the capital dividend account works in the ordinary case is on the glossary page.

There was one door left open, and it closed long ago. Subsection 148(5) provided that where a policyholder, after March 20, 2013 and before April 2014, disposed of an interest in a 10/8 policy by a partial or complete surrender in order to repay the borrowing, a defined amount of the resulting income inclusion was relieved. That window ended in 2014. A person still carrying such a contract has no comparable relief in the Act, and what to do with it is a question for a Chartered Professional Accountant.

What does the Act do today to an LIA policy?

Four things. Paragraph 20(1)(e.2) excludes an LIA policy from the premium deduction at its opening words. Subsection 306(1) of the Income Tax Regulations excludes it from the definition of exempt policy. The capital dividend account definition excludes its proceeds. And subsection 70(5.31) values the annuity at death at the premiums paid under it.

The definition again comes first. An LIA policy under subsection 248(1) is a life insurance policy, other than an annuity, where a particular person or partnership becomes obligated after March 20, 2013 to repay an amount to a lender at a time determined by reference to the death of a particular individual whose life is insured under the policy, and the lender is assigned an interest in both the policy and an annuity contract whose terms provide that payments continue for a period ending no earlier than that individual's death. The two hallmarks are a repayment timed to the death and a lender holding both contracts as security.

The premium deduction goes at the door. Paragraph 20(1)(e.2) allows the least of three amounts in respect of a life insurance policy, other than an annuity contract or an LIA policy. A caught contract never reaches the three amounts. That single parenthetical removes the second of the three offsets described above, and it does so without regard to who the lender is or what the money was used for.

The exempt status goes next, and this is the consequence most often missed. Subsection 306(1) of the Income Tax Regulations defines an exempt policy, for the purposes of that Part and of subsection 12.2(11) of the Act, as a life insurance policy other than an annuity contract, an LIA policy or a deposit administration fund policy. A contract that is not an exempt policy is subject to the annual accrual rules in section 12.2 of the Act, so the growth inside it is taxed year by year rather than deferred. Whatever the illustration said about tax-deferred accumulation stops being true on the day the contract becomes an LIA policy.

Then the capital dividend account. Subparagraph (d)(ii) of the definition in subsection 89(1) adds the proceeds of a life insurance policy, other than an LIA policy, received in consequence of a death. The death benefit still repays the lender, but nothing flows into the account, and nothing can be paid to shareholders as a capital dividend on the strength of it.

Finally, the valuation. Subsection 70(5.31) provides, for the purposes of the deemed disposition at death under subsection 70(5) and the trust rule in subsection 104(4), that the fair market value of an annuity contract that is the contract described in subparagraph (b)(ii) of the LIA policy definition is the total of the premiums paid under it on or before the death. The annuity that was worth almost nothing at death is now worth what was paid for it, and the deemed disposition catches the capital that the arrangement was built to keep out of it.

What must an arrangement look like today to stay outside these definitions?

It must not credit a return that depends on the loan, must not cap an account by reference to the loan, and must not time repayment to a death with an annuity assigned beside the contract. Those are the facts the definitions in subsection 248(1) look for, and a label on a proposal does not change them.

Start with the 10/8 branch. The first test in the definition asks whether the return credited to an account inside the contract is determined by reference to the rate on the borrowing and would not be credited without it. A participating whole life contract credits dividends declared by the insurer for every contract of its class, whether or not any particular holder has borrowed, and those dividends are not guaranteed. A credited rate that would be paid to a holder with no loan at all is, on the face of the definition, not a return that would not be credited if the borrowing were not in existence.

The second test asks whether the maximum amount of the account is determined by reference to the amount of the borrowing. The exempt test under section 306 of the Income Tax Regulations sets the ceiling on accumulation inside a contract, and that ceiling is set by the contract's death benefit and the prescribed formula, not by any loan. An arrangement in which the lender, not the insurer, decides how much to advance, and the insurer, not the lender, decides what is credited, keeps the two amounts independent, which is what the definition requires.

Then the LIA branch. The definition needs a repayment obligation timed by reference to the death of the individual insured and a lender assigned an interest in both the contract and a life annuity on that individual. An ordinary loan secured by a contract, repayable on demand or on a term, with no annuity in the arrangement at all, has neither hallmark. The moment a life annuity on the same individual is added and assigned to the same lender, the question changes, and it is a question for a Chartered Professional Accountant before any document is signed.

Two further points keep this section honest. First, staying outside the definitions earns nothing on its own: the interest deduction under paragraph 20(1)(c) still depends on the borrowed money being used to earn income from a business or property, and the premium deduction under paragraph 20(1)(e.2) still depends on its own conditions, both explained on the arrangement's own page. Second, the state this practice calls Infinite Financial Sovereignty®, holding the highest practical level of control over the capital-flow function in one's own affairs, is a matter of who decides when capital moves, and an arrangement that hands that decision to a lender in exchange for a deduction has given away what it was meant to secure.

Who this suits, and who it does not

It suits a business owner shown a leveraged arrangement who wants to know, before signing, which provisions of the Income Tax Act it was tested against. It suits a person with an older contract who wonders whether the phrase 10/8 describes what they own. And it suits anyone told that a current arrangement is the old one renamed.

It does not suit a person looking for a structure in which the tax result pays for the borrowing, because the provisions above exist to remove exactly that and no arrangement this practice would describe is built on it. It does not suit a person who cannot carry the interest from their own cash flow if every deduction were denied, because the lender is paid in cash and not in deductions. And it does not suit anyone who wants an opinion on their own contract, loan or corporation, because that opinion belongs to a Chartered Professional Accountant reading the documents, and to nobody writing a page.

Everything here is written by a person paid by commission from an insurer when a contract is issued, which is stated at the foot of every page. Leverage is a choice made after the contract, never the reason for it, and the two arrangements this page describes were ended because they reversed that order. Whether any borrowing against a contract belongs in a particular set of affairs is a question for a Chartered Professional Accountant and a lawyer or, in Quebec, a notary; this page is only a map of where the statute draws its lines.