A few days after the March 21st Federal Budget I had a great learning experience when I sat down with Trevor Parry who is currently completing a LLM in Taxation Law at Osgoode Hall Law School and is the Executive Vice-President of Gordon B. Lang & Associates Inc, Canada’s leading actuary firm for individual pension plans (IPP) and life insurance valuations. Our topic that day was on the“all dividends” compensation strategy and for this column I would like to share with you want insight I gained that day.

Trevor had sat on the sidelines as he watched over the last few years, how many accountants across Canada have advocated an all dividends compensation strategy for their business owner and incorporated professional clients.  They have advocated this as a means for realizing significant tax savings for those individuals.  It has been the stated policy of most governments in Canada to reduce corporate taxation as a means of spurring economic activity.

“While this policy goal is praiseworthy, and somewhat successful it was not accompanied by diligent attention to maintaining integration.  Integration, a cornerstone of tax policy since the Carter Commission asserts that an individual should not be advantaged based on the nature of compensation, either dividends or salary and bonus”, pointed out Trevor.  As provincial governments, notably Ontario, abandoned any sense of fiscal discipline, the gap between the taxation of dividends and income has widened.  In some provinces like B.C and Alberta it was only around 1% on non-eligible dividends, while in Ontario the gap was in excess of 4%.

In addition to this ‘integration gap’ “those who were paid only in dividends were not required to remit to the Canada Pension Plan, or pay the host of provincial payroll taxes such as Quebec’s Health Tax and Ontario’s Employer Health Tax.  The result was that those who set their own compensation enjoyed robust tax savings and governments saw a reduction in revenue”, shared Trevor.  It was not a feat of clairvoyance then to see Mr. Flaherty tackle this issue in his 2013 federal budget.   The taxation of non-eligible dividends has not been substantially re-integrated.  The reduction in the gross up has effectively increased the taxation of the non-eligible dividend by just less than 2%.  One would assume that given Ontario’s fiscal quagmire the remaining “integration gap” will be addressed in Mr. Souza’s first budget.

“The all dividend strategy was a product of spreadsheet analysis.  As anyone with some life experience would know, life rarely emulates a spread sheet”, smiled Trevor.  Individuals hopefully make decisions on the basis of objective review and analysis of costs and benefits, but experience would indicate otherwise.  “Human nature is rarely ‘best interested’ it is almost always ‘self-interested’.  Ask yourself how many people who embarked on the ‘all dividends’ strategy actually saved the taxes saved? How many people took the money that would have otherwise been remitted to the CPP and instead deposited it into their Tax Free Savings Account (TFSA)?  I think we all know the answer; the extreme minority”, points out Trevor.

Trevor and my discussion moved into the simple demographic reality that the baby boom generation is in the early stages of retirement and that most individuals have done inadequate savings for that eventuality.

“It is time to address the need for savings and the need for certainty in retirement planning.  I believe that Mr. Flaherty’s actions will breathe new life into the Individual Pension Plan”, says Trevor.  With large past service contributions available (oh yes that’s right the 2011 Budget proposals to restrict or eliminate past service were withdrawn) a business owner has the ability to fund a large pension plan for themselves and their employed family members.

In addition to large deductions up front (maybe $250,000 or more) a business owner has the ability to dial down risk and enhance overall deductions going forward.  The IPP is based on an annual assumed growth rate of 7.5%.  Unless you enjoy investing in the debt offerings of Greece, Spain, Cyprus or Portugal guaranteed rates of return are considerably less.  My experience is that IPP portfolios tend to be of a lower risk nature; this is because they have been legislated to take much less risk with their portfolios.  Plans return safely 4 or 5 per cent and every three years the “deficiency” is calculated.  Funding that deficiency is a complete deduction to the sponsoring company.

In certain provinces IPPs have no mandatory funding.  That means if the company cannot fund the plan, they are not required to.  Therefore businesses that set up IPPs are not putting their head into the noose associated with Defined Benefit Plans. IPPs are also creditor protected and all investment management fees are deductible, two attributes not found with RRSPs.

As our conversation came to a close, Trevor reminded me that the IPP is a Defined Benefit plan which means that you know exactly what you are getting and when you are getting it.  That makes retirement planning a great deal easier and tends to reduce stress.  “Business owners should look down the street to their neighbours, the retired school teachers.  How many teachers suffer in retirement? For them retirement is a certainty.  Isn’t it time that business owners and professionals seek the same and shouldn’t their trusted advisors assist their clients properly evaluate all tax and retirement options “, smiled Trevor as our lesson came to a close.

“Did you read, the government is eliminating unintended tax benefits related to leveraged life insurance arrangements? What does this mean to our wealthy clients who have implemented such structures?”

In essence, what Flaherty had proposed in his budget was the elimination of what the government believes are unintended tax benefits relating to leveraged life insurance arrangements, referred to in insurance industry lexicon as the 10-8 arrangement.

What was the 10-8?
The 10-8 arrangement involved an exempt universal life insurance policy and leveraging. This was an arrangement that first required that a client’s insurance needs be identified and established (such as funding tax needs at death, buy-sell funding, key person insurance, and charitable gifting) prior to any consideration being given to a 10-8 arrangement.

Once the insurance had been acquired, a policy holder could deposit additional funds into the policy, which created cash surrender value (CSV) in the policy. In appropriate cases, the CSV could have been used as collateral security for a loan. The loan carried a 10-per-cent annual interest, which would be deductible for tax purposes if the loan were used for income-producing purposes. A portion of the premium associated with the policy could have also been deductible, provided that the 10-8 borrowing complied with the requirements of the Income Tax Act.

Not all life insurers in Canada offered the 10-8 arrangement. Of those who did, the loan was either a collateral loan or a policy loan. A policy loan is a loan by an insurer to the policy holder, which is made according to the terms of the policy. Policy loans were limited by the “adjusted cost basis” of the policy, and, after a point in time, loan proceeds could be taxable. Collateral loans, by comparison, were made using the policy CSV as security for the loan, and were made pursuant to the terms of a loan agreement, not the policy itself.

Collateral loans were not limited by the adjusted cost basis of the policy. Interests on both types of loans were deductible provided that the loans were used for income-producing purposes. While the loan was outstanding, the policy CSV accumulates at an 8-per-cent rate. The value of this arrangement was that these policies were exempt policies, the 8 per cent accumulates on a tax-deferred basis, and were made available for a further loan to the policyholder at the end of a particular policy year.

Post 2013 Budget
Under the proposed changes, when an investment account or a life insurance policy under the policy is used as security for a loan, and either the maximum value of an investment account under the policy is set by reference to the loan or the interest rate on the investment account under the policy is set by using the interest rate payable on the loan, then the following income tax benefits will be denied:

- The deductibility of the interest paid or payable on the borrowings that relates to a period after 2013;
- The deductibility of a premium that is paid or payable under the policy that relates to a period after 2013;
- The increase in the capital dividend account by the amount of the death benefit that becomes payable after 2013 under the policy and that is associated with the borrowing.

For several years, CRA has wanted to get rid of all existing 10-8 arrangements and had failed on several occasions in Canadian courts, as recently as Feb. 21. So, in one swoop, the 2013 budget proposes as the legislation sits today without any amendments that all 10-8 insurance arrangements must wind down before 2014.

Within Flaherty’s 2013 Budget, he proposes to alleviate the income tax consequences on a withdrawal from a 10-8 arrangement.  The Budget states that if a borrowed amount under the arrangement is repaid after March 21, 2013 and before Jan. 1, 2014, there will be no tax consequences.

The problems that Flaherty’s budget does not address if a 10-8 loan is replaced by bank financing are:

- The loan value may be calculated as a percentage of the account value and the cash surrender value in the policy may be lower. The client may have to qualify for a bank loan where the collateral of the policy is insufficient to be approved for such loans.
- The interest rate charged for the new bank loan is not fixed and can fluctuate unlike the 10-8 arrangement where the loan rate was guaranteed for the life of the policy at 10 per cent.

- The return on investments in the policy is not guaranteed and is subject to market fluctuations or, if in a fixed term investment, at a low rate unlike the 10-8 arrangement where the rate of return was guaranteed at 8 per cent as long as the loan was being paid. This could create a scenario where the interest rate is higher than the rate of return both before and after tax.

The main reasons why the wind down of the 10-8 arrangement may not be equitable for most individuals who have legitimately put them in place since 1986 are:

- If policy owner is not eligible for a bank loan, your clients will suffer a 2-per-cent negative spread between what they pay for the interest for the policy loan and what is actually credited to the policy.

- For those who cannot afford to keep their policies with the Income Tax Act changes and are uninsurable, they may have to lapse their policies because of unbearable cost burdens created by the budget.

- There will be substantial cost to cancelling most of these policies.
These are just some of the issues that owners of insurance policies and their public accountants need to concern themselves with. Another pending change was proposed in the 2012 federal budget where the government stated that it plans to make changes to the life insurance exemption test on all policies that are put in place after Jan. 1, 2014.

Life insurance policies are subject to an annual test called the exemption test. Under the Income Tax Act, the internal growth of the cash value of policies issued today is not subject to accrual taxation (i.e. annual taxation on cash value growth), provided the policy growth falls within the parameters of a prescribed test policy. The test policy is a 20 Payment Endowment at age 85. Policies that meet this test annually are considered “exempt” and are exempt from accrual taxation.

The Bottom Line
Governments around the world, including our own, are strapped for cash and are enacting draconian methods to increase revenues. That being said, a permanent life insurance policy is still the best financial tool in Canada that efficiently provides cash on death. But what is important now for your clients who have already implemented a 10-8 arrangement is to sit with an insurance and tax expert to evaluate their options. There are less than a dozen insurance experts across our great land who have the expertise to advise your clients on what their next move should be. Unfortunately, most likely the insurance agent that placed your client into one of these 10-8 arrangements is not one of those experts for winding it down.

Within days of Finance Minister Jim Flaherty tabling of his 2013 budget, where he again attacked life insurance in his second consecutive budget, I began a fruitful dialogue with Jack Brown, a three decade life insurance veteran and the technology chair at PPI, Canada’s largest life insurance managing general agent to discuss the topic of the effective rate of return of a life insurance policy compared to other financial instruments.

In this month’s column I would like to share with you, what I learned, why a permanent life insurance policy is still the best financial tool in Canada that efficiently provides lump sum tax free cash at death with the help of my lessons with Jack Brown.

A permanent life insurance policy is a financial tool that efficiently provides cash at death. But a life insurance policy is only one way of providing cash at death.  So I asked Jack: How can one compare the efficiency of life insurance against other financial strategies being presented to clients in the market place today?

Jack turned to me and said “we can first look at the traditional approach of evaluating any type of investment by using the Internal Rate of Return (IRR). The traditional method used to measure the efficiency of life insurance is to calculate the IRR at a probable date of maturity.”

Jack further explained that IRR calculations treat the policy premiums as cash outflows and the death benefit as a cash inflow. It then determines what rate of return those premiums would need to generate if they were invested elsewhere, so that they would accumulate to an amount equal to the policy death benefit. This rate of return is then compared to other investment opportunities to determine the relative effectiveness of life insurance as a financial instrument.

“Most life insurance policies have pre-determined premium levels and premium payment periods; however, the date when the death benefit will be paid is unknown. A common practice is to assume that event will occur at the insured’s life expectancy”, shared Jack.

The example Jack used to explain this during our lessons was that of a 40 male, non-smoker who makes a premium deposit of $8,345, for life, who is in a 43.7% marginal tax bracket. He would need to achieve a 7.27% pre-tax return each year in an alternate investment to produce $1,000,000 of after tax capital at his life expectancy age of 84.

Jack then pointed out how the IRR approach has serious shortcomings because it failed to account for an earlier death of this individual. “Permanent life insurance pays the full coverage amount of the policy regardless of when death occurs. This is a major advantage over other capital accumulation strategies”.

For example, should death occur in the first year, this life insurance would pay the full target amount of $1,000,000, while an alternate investment would only provide the deposits plus any accumulated investment returns that would be taxed.

The traditional IRR calculation does not account for this early payout possibility.
“A true comparison calculation should include an adjustment for the insured payout contingency”, stresses Jack. The new approach that Jack recommends be adopted is to use the Effective Rate of Return (ERR) to compare insurance to other financial instruments.

If we assume that we purchase term life insurance each year to cover the shortfall we could remove the payout risk of an early death. To account for the annual insurance purchase, we would subtract the cost of that insurance from any investment accumulation, giving us a more accurate picture of the true return on the premium investment in the permanent policy.

Returning to our example, if our target accumulated amount or death benefit is $1,000,000 and the first year deposit is $8,345, should death occur in the first year there would be a shortfall of $991,665 in our accumulated investment fund. That shortfall could be covered by purchasing one year of term insurance. The cost of that insurance coverage of $1,125 would be deducted from the accumulated funds. The result would be a $1,000,000 payment upon death in year one.

The Calculation Cycle

To calculate the ERR at any point in time; Jack explained that there are four steps in the calculation cycle that need to be repeated annually. Jack’s four steps are:

1. Any new deposits are added to the investment accumulation fund.
2. The shortfall from our target accumulation amount should death occur in that year is the amount of term life insurance required to make up the difference for that year.
3. The cost of the insurance coverage is deducted from the accumulation fund.
4. The investment returns on the remaining accumulation fund are added to the balance.

“The ERR calculation solves what the investment return is required each year in step 4 in order to achieve the target accumulation amount at a point in time, for example, life expectancy”, adds Jack.

After learning this I came to understand why the ERR is the only true measure of efficiency. Using our earlier example of a male 40 non-smoker with $1,000,000 of coverage and a premium of $8,345, for life, in a 43.7% marginal tax bracket, the ERR pre-tax equivalent at life expectancy of age 84 would be 10.00%.

In other words, an alternate investment would need to return more than 10.00% annually pre-tax to accumulate to an amount equal to the policy death benefit, while providing the same potential payout each year.

The Bottom Line

As my education with Jack drew to a close, he shared these last insights: “Although there are many factors to consider when allocating funds between insurance and investments, the ERR calculation provides a quantifiable approach that can contribute to the decision process. Since death is unpredictable, this new method of measuring insurance efficiency allows us to look at the ERR of the permanent policy for dates other than just life expectancy.”

In addition ERR is a better method than IRR to measure the efficiency of a life insurance contract against other investments, as it accounts for the risk that death may occur earlier than life expectancy. This is why there is not a bigger bang for ones buck than a permanent life insurance policy. Life Insurance is still the best financial tool left in Canada that efficiently provides lump sum tax free cash at death.

Perhaps it is time for your clients to have an ERR analysis done one their estate planning needs using Jack’s 4 step Calculation Cycle so they know their options.

This is not so easy anymore as Canadian regulators strengthen consumer protection and outline corporate responsibility for their employment benefit plans. In 2006, the Canadian Association of Pension Supervisory Authorities (CAPSA) mandated that all CAPs comply with guidelines developed by the Canadian Joint Forum of Financial Market Regulators. For the past 7 years most corporate sponsored CAPs have been mandated to follow these CAP Guidelines.

The essence of these guidelines is employers can be held responsible for investment loses for their employees who are invested in a company sponsored CAP. As employees learn their legal rights, a company’s fiduciary obligations could perhaps be the most worrying of all for employers.

CAPSA and the Joint Forum of Financial Market Regulators have initiated raising the fiduciary responsibility bar on all employer-sponsored savings plans. A wise solution to mitigating potential future liability/risk for all employer-sponsored CAPs would be for companies to set aside between 1% and 5% of the total compensation for their people and to hire an independent financial planning solutions provider. Thus, their employees would then individually create and maintain a comprehensive financial plan custom-tailored for them alone. How would this work?

Imagine we are dealing with a technology company that has a specialized department of 20 highly skilled software engineers who earn an average of $100,000 per year, with a total payroll of $2 million. The company’s gross annual revenue attributed to the vital work of each of these employees is $1 million for a total of $20 million from this one department.

Each year, the company has a personal turnover of 20% (four employees) from this department’s workforce. To replace each engineer who leaves the department with another qualified engineer, it costs this company $30,000 in finder fees to pay a head hunting firm for assistance to find one replacement. It takes an average of 18 months for the replacement computer engineer to learn his or her job effectively and to generate a profit for the company.

This year, the company has decided as a retention strategy for this department to implement a financial planning benefit for each of its 20 employees. It has earmarked the equivalent of 5% of its total payroll ($100,000) for this department towards the creation of a personal financial planning benefit. The aim of this benefit is to give each employee the wherewithal to take responsibility and be empowered to integrate the company’s entire benefit plan with what they are doing outside the company with their entire financials, thus creating a community and a strong feeling among the employees toward the company that they belong to.

The goal of this new benefit is to create an environment that gives each of these engineers peace of mind, with a new ability to see how his or her personal success relates to the company’s success in a tangible way, through the creation of the personal financial planning benefit. The desired goal is to create a greater commitment towards the company, reduce turnover and increase productivity.

At the first year anniversary of the financial planning benefit, the company witnesses its turnover drop by 50% (two employees leaving compared to the four the year earlier) and the productivity for each employee increase by 10% ($2 million). For a $100,000 investment in the first year of implementing this financial planning benefit program, this company has made a quantifiable return on its investment of $4,260,000 in productivity gains and a reduction in employee turnover. After ten years of implementing this benefit plan, the company could see a return on its investment of $42,600,000 in productivity gains and a reduction in employee turnover for as little as its $1 million investment into this benefit and its people.

One way some Canadian employers are meeting the aim of encouraging employees to save for retirement, while also reducing corporate fiduciary responsibilities, is not to promote, administer or offer any type of company-sponsored savings plans at all. Instead, these companies are opting to write cheques directly to an employee’s personal RRSP at a RRSP provider of the employee’s choice such as: financial planning firms, banks, trust companies, insurance companies, mutual fund companies or online brokerages. The only condition these companies place on their contributions into an employee’s RRSP is to have proof provided that an RRSP is active.

Having an employer contribute directly into an employee’s individual RRSP can be a little tricky since CRA only allows individuals not corporations to make contributions into these plans. Companies are able to get around this by raising employees’ salaries to match their contributions. The tax on this pay increase earmarked for an RRSP can be avoided if the employee or company submits a CRA Tax Waiver Form regarding these contributions.

There are some downsides to this approach. The company will be giving employees complete control over the company’s contributions to workers’ RRSPs. Employees choose how they will invest this money, and have complete autonomy whether the money remains or if it is withdrawn from their retirement plans. In addition, employees who earn less than the maximum salary limit for CCP and EI will be subjected to CCP and EI premiums increases. Employees who earn more than these amounts will not be affected.

Canadian employers need to rethink corporate benefit plans. In the 21st century, the individual financial plan should be the modern company’s core employee benefit. The financial plan makes the distinction between the financial planning process and the old world’s focus on financial products. A financial planning benefit solution is the one tool that will help employers surpass regulatory benchmarks in the most cost-effective way.

A financial plan helps employees understand how their employee benefit programs form a part of their financial foundation while understanding that their employee benefit programs are not the total foundation for them to get the life they want as they plan their future and retirement.

For those clients asking, yes there is substantial tax relief available for clients finding themselves in this situation who own businesses; this can be done by establishing a Health Spending Account (HSA) for their company or themselves.

How does a HSA work?

An incorporated business establishes a specialty healthcare trust to pay for the HSA member’s (and family’s) health care costs. HSAs follow the framework laid down in S. 248(1) of the Income Tax Act and CRA’s Interpretation Bulletins IT-85R2, IT-339R2, and IT-519. In order for CRA to allow for the cost of medical and dental expenses to be tax deductible for an employer and the benefits to be non-taxable in the hands of employees the administration and adjudication of claims of HSA must be operated through third party trustees that specialize in the administration of these types of plans.

Between the Medical Expense Tax Credit (METC) outlined in Section 118.2(2) of the Income Tax Act and 5700 in the Income Tax Regulation there are over 60 different eligible expenses available for individual taxpayers to claim as METCs for themselves and their dependents who have been diagnosed with having learning disabilities on their after taxed expenses. By creating a HSA a business owner can turn these same expenses into corporate deductions.

The most popular special expenses unique to learning disabilities that can be claimed through a HSA are:

Psychological Assessment: The cost of psychological assessments to determine if there is a diagnosis of a learning disability by either a registered psychologist or medical doctor.

Tutoring: The cost of tutoring to help with the four basic academic skills such as reading, spelling, writing and math provided these services are recommended in writing by either a doctor or registered psychologist as a remedy for the learning disability. For these tutoring services to qualify these services must not be provided by a family member.

Talking Textbooks: The cost of talking textbooks that have been prescribed in writing by a medical practitioner or psychologist for use by an individual with a learning disability. These talking textbooks must be needed in connection with the individual’s enrolment in a Canadian educational institution.

Transportation and Traveling: The cost for transportation and traveling to and from assessments, therapy, special educational facilities, special camps and tutoring sessions for the individual with the learning disability. If an individual with the learning disability needs to be accompanied by another person when traveling, the expenses for this traveling companion can be claimed through the HSA provided that a qualified person (medical doctor or registered psychologist) has certified that the person with a learning disability needs this assistance while traveling.

Specialized Private Schools, Camps and Other Educational Institutions: The cost of specialized private schools, camps and other educational institutions can be put through a HSA in accordance with the rules set down in S. 118.2(2) of the Income Tax Act provided that the following three criteria have been met:

Criteria One: A qualified person has certified that the individual has a learning disability;

Criteria Two: A qualified person certifies that the individual with the learning disability requires the equipment, facilities and personnel specialties provided by a named private school, camp or other educational institution;

Criteria Three: The specialized private school, camp or other educational institution has the required equipment, facilities and personnel to assist the individual with his/her learning disability needs.

Example: Imagine you have a client who has an incorporated business in Ontario who earns a T4 income of $200,000 and has a marginal tax rate of 46.41%. This client has a child who has been diagnosed with a learning disability by a certified child psychologist (Criteria One met).

This psychologist recommends in writing that the best educational day facility in Ontario to meet this child’s learning and developmental needs as a person with a learning disability is King Heights Academy, in Woodbridge, Ontario. King Heights Academy has been widely recognized by qualified persons in the Greater Toronto Area in meeting the special needs of children with Learning Disabilities (Criteria Two met).

King Heights Academy currently has in place the facilities and personnel to meet the educational needs for children who have been diagnosed with learning disabilities (Criteria Three met).

The school fee for attending King Heights Academy for the entire 2013-2014 academic year is approximately $11,000.

Now let us compare this client’s two options and find out what the final financial outcomes for each are: In Option 1, the client plans to pay for the entire school fee with their after tax dollars. In Option 2, the client has set-up a HSA with their company and plans to pay for the entire school fee through the trust.

In Option 1, the client will have to earn approximately $21,210 of personal income before taxes to pay with after tax dollars the school fees of $11,000. The school fees will have to be paid before the client can be eligible to apply for a personal non-refundable Medical Expense Tax Credit (METC) of $1,892.

In Option 2, the client’s company through using the HSA Solution will pay $12,100 ($11,000 school fees plus $1,100 administration fee of 10 percent) into the HSA. The total savings this client and his company receive for opting for Option 1 and setting-up the HSA and then claiming the King Heights Academy fees through the HSA is $7,218 over staying with Option 2 that included the METC. This savings equals approximately 70% of King Height Academy’s entire school fees.

HSA require specialties in employment compensation, adjudication of eligible claims and benefit plan construction. Therefore if you are evaluating the suitability of a HSA for your clients or yourself it is well worth the time and money to hire the right professionals to assist in the design, implementation, maintenance and adjudicate the claims within the HSA Solution.

With 25 years of public accounting experience and his experience in business valuations, Jeff began to educate me on subsection 70(5) of the ITA that requires that the fair market value of a business, shares or property be determined “immediately before the taxpayer’s death” this can create significant tax burdens on death. Yes there are spousal rollovers, if you have a spouse at the time of death, but this may not be set out in the will or eventually the spouse will die.

“If a client is a shareholder of a corporation and they have planned for this they can mitigate this problem by having an agreed upon clause in their Shareholders’ Agreement that meets specific criteria required by CRA”, shares Jeff. But what if your client is the only shareholder or they are not at arm’s length to the other shareholders – CRA’s view is that the Fair Market Value (FMV) of the shares is to be determined immediately before death and will be based on the facts of situation at that time.

Jeff further explained that when a shareholder dies the purchase requirements within a shareholders’ agreement are hopefully funded by the proceeds of a life insurance policy. This eliminates the financial burden put on the company and or the surviving shareholders that have to buy out the deceased estate. He also noted that a FMV valuation includes individual goodwill (unlike personal goodwill) – which is commercial. Without a bona fide agreement to adjust for this goodwill, from a valuation point of view the individual goodwill does not expire before death. This may be the case even if all of the goodwill is eventually lost after death. This is rarely ever accounted for in the estate planning.

The question that Jeff shared that needs to be addressed with respect to insurance in the company is what is its effect on share value? For the insurance policy of the deceased it is the cash surrender value that determines the value of the policy on death even though it is not the proceeds one must be careful of the amount of Cash Surrender Value (CSV). A potential bigger issue is if there are policies on the other shareholders lives which may be valued at the FMV, which is likely much higher if the shareholders are older and have had the policies for some time. Furthermore either of these could put your deceased client offside for the qualified small business corporation (QSBC) and capital gains exemption (CGE).  An option would be to hold the life insurance policy in a holdco while retaining opco shares to take advantage of the exemption.

It is incorrectly assumed that the tax results to the estate will be the same if the value goes down after death and the loss is carried back. The reason being that, “this carry back may not be available if the shares are not sold within the first taxation year of the estate, the other shareholders have not exercised their option to buy or other potential issues if the other shareholders are not at arm’s length”, shares Jeff.

To illustrate these issues Jeff provided me with the following example. Imagine client “Mr. G”, who is the sole shareholder of ABC Wholesaling. Mr. G’s wife predeceased him and neither Mr. G nor his wife believed in life insurance and had none. Mr. G has two children, one who is a business person and one who is a teacher.

Assume Mr. G dies with only assets being ABC Wholesaling and his principal residence. Mr. G had decided to leave the business to Child C and the House to Child D thinking that after the capital gains tax of 23.2% the two kids would get the same value.

Subsection 70(5) of the Income Tax Act requires that the fair market value of the business, shares or property be determined “immediately before the taxpayer’s death.” Again it needs to be noted that valuations include Individual goodwill (unlike personal goodwill) – which is commercial and without a bona fide agreement to account for the valuation methodology, from a valuation point of view the individual goodwill does not expire before death. This may be the case even if all of the goodwill is lost after death.

ABC Wholesaling’s fair market value immediately before death was $2.6 million, less the tax on deemed dispositions at 46.4% x 50% of the gain of $603,200 tax, leaving an after tax value of $1,996,800. The market value of his principal residence is $2 million and because it is a principle residence there is no tax on it.

However the estate and Child C had no liquid cash to pay the tax. Therefore ABC Holdings had to pay out what cash it had and borrow the remaining funds to pay out to Child C. Since there was no capital dividend account the funds had to be paid out as a taxable dividend and thus increased in order to have the after dividend tax amount of $603,200. So the total dividend would have to be about $895,000. Tax on the dividend is at 32.6%, so there would be approximately $292,000 in personal tax paid. The effective tax rate to transfer the business to Child C is 34.42%. This is 1.5 times what Mr. G had thought it would be.

To make matters worse the combination of: 1) the additional financial burden on the company after having to pay out more than 1/3 of its value (the $895,000 dividend); 2)the lack of focus as a result of bereavement Child C was facing and 3) the lack of a transition plan caused the business of ABC Wholesaling to suffer. Within 2 years the value of ABC Wholesaling declined to about $500,000. Child C sold the business to a competitor and incurred a loss of $2,100,000. This loss could not be carried back to the Estate’s return so in the end Child C paid a total of $894K in tax on an asset that was eventually disposed of for $500K or the tax was 178% of the actual proceeds on disposition. Note this could be even higher if there are imbedded taxes due on the sale of assets.

Mr. G could have avoided this terrible situation with proper planning pre-mortem, proper planning post-mortem and acquiring adequate insurance. With the assistance of a CBV in conjunction with other trusted advisors including a skilled competent insurance professional these issues could have been mitigated or perhaps avoided with planning and preparing a succession and continuation plan.

Ideally business owners should have their companies valued if a proper estate plan is to be done as the business could likely be the most significant asset of the estate.

Perhaps former US President Calvin Coolidge sums up this belief best:

“Nothing in this world can take the place of persistence. Talent will not; nothing is more common than unsuccessful people with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent. The slogan “press on” has solved and always will solve the problems of the human race” 

With years at the back of my sails, I have learned to appreciate the wisdom once spoken long ago by the likes of Aesop, Coolidge along with that of Oscar Wilde’s definition of what a cynic is: “A cynic is a man who knows the price of everything and the value of nothing.” To be successful in any endeavor we need to surround ourselves with the right people whose outlook towards life and personal goals are in-line with our own, who see our intrinsic value, not our price.

Another way to look at intrinsic value is to learn from James Carse’s book Finite and Infinite Games. In it he introduces and then defines that there are only two kinds of games/lenses to view our subjective worldviews. One could be called finite, the other infinite. A finite game is played for the purpose of winning, an infinite game for the purpose of continuing the play.

It absolutely makes a world of difference whether we consider ourselves as pawns in a game whose rules we call reality or as players of the game who know that rules are “real” only to the extent that we have created or accepted them, and that we can change them.

One way or another, most of us believe circumstances are the driving forces of our lives. But if we step back, we will slowly realize it is not our circumstances but how we have structured our work, thinking and who we have invited into our lives and career that creates our outcomes. The underlying structure of one’s life determines the path one takes. By changing our structure, we change our lives.

The first step is to understand that any relationship or process can be characterized in “finite” or “infinite” terms. The second step is recognizing that characterization is almost always a matter of choice and that, by choosing to see a relationship as “infinite”, you can redefine it in a meaningful and healthy way.

I have observed that when people see life as an infinite game and are living out their life purpose, they come up with more ideas, see more associations between ideas and people and see more similarities and differences among things than people who see life as a finite game. What emerges is more of a partnership orientation towards family, friends, work, communities, environment, life and ourselves. Infinite gamers take the long-view in much of what they do. Their primary aim is to create a win/win environment in every activity they partake in with others because anything lesser will end their ability to truly experience and enjoy their life.

It has been said that when a person has one way of doing something, he or she is stuck; if that person has two ways, he or she is in a bind; and only when that person has three or more ways of doing something, he or she has true choice. The Chinese symbol for “crisis” has a duel meaning, which also translates into the word “opportunity”. Each player in the game of life who is perceptive enough to see himself or herself playing in an infinite game has the uncanny ability to see all crises as opportunities to continue to play. So all that happens to this kind of person in life is a part of the play, and there are no failures in the mind of this kind of player; there is only feedback so play can continue.

A major influence on Warren Buffett’s investment philosophy was the investing legend Philip Fisher, author of the 1958 investment classic Common Stocks and Uncommon Profits. Fisher adamantly believed in never investing money with a man who had never fallen flat on his face, broken some bones, knocked out a few teeth and failed miserably at least once in his lifetime, and then pulled himself up by his own bootstraps through sheer inspiration, determination and perspiration. This individual was a creative force to be reckoned with and could be counted on as a leader in the land of the living.

This type of person, Fisher believed had an indelible spirit, a moral compass and a strong defining character (an infinite gamer at his or her very best). This was the kind of person whom Fisher wanted on his team and would invest his, his partners’ and his clients’ time and money in for the long haul because this type of person had shown through adversity that he or she would not allow himself or herself to be counted out, and was a serious player in the game of life.

Don Juan the celebrated Renaissance lover and warrior observed: “The basic difference between an ordinary man and a warrior is that a warrior takes everything as a challenge, while an ordinary man takes everything as a blessing or curse.”

A common denominator of advice gleaned from these sages that we can all take and apply today as we continue to build both our lives and careers is: all of our failures in life are events the full benefits of which we had not yet turned into our advantage.

As we continued our conversation about the other tax potholes that public accountants can avoid by having access to the proper resources and experts, Michael’s comment about offshore insurance lingered in my mind. The question of the why behind Michael’s statement is the focus of this month’s column.

By offshore life insurance policies we also need to include US life insurance policies. Firstly the application has to be completed and signed outside Canada.  If not, the insurance company is operating in Canada without a license and the insurance agent is selling an insurance policy for an unlicensed insurer.  Any additional documents that are required also need to be completed and signed outside Canada and the policy itself has to be delivered to the policy owner outside Canada.  Provided the policy is a term insurance policy there are no further complications.

Is there any advantage to doing this? No.

• A policy issued in Canada that has a preferred beneficiary is protected from creditors.
• If the policy has been obtained outside Canada the cost of obtaining the policy would be far greater than any saving in the cost of insurance.

Let us look at a policy that has a cash value. The same constraints apply to this type of policy as term insurance with some additional problems which clients and tax practitioners need to be aware of.

A policy that has a cash value and is issued in Canada has to comply with tax regulations regarding the accumulation of cash within the policy. The cash value cannot exceed the MTAR (maximum tax actuarial reserve) as defined in the Income Tax Act.  If the policy does exceed the MTAR, the policy is no longer tax exempt and the cash buildup in the policy becomes taxable. A policy that is issued by an insurance company outside Canada does not conform to the MTAR regulations and any increase in the policy value is taxable.  Since Canadians are obliged to report worldwide income the increase in the policy value would have to be reported. Tax would have to be paid notwithstanding that no funds were received. If the increase in policy value is not reported, it is tax evasion.

Secondly there is an exposure to currency risk. Most offshore policies are issued in US dollars.

The exchange rate between the Canadian dollar and the US dollar is at the moment roughly parity. On January 21^st 2002 the exchange rate was 1 Canadian dollar to .62c US. To buy a US dollar you would have to have paid 1.61 Canadian. If you bought a policy today and the Canadian dollar dropped to this level again, you are effectively paying 62% more in premiums.  If the dollar then went back to parity, you would have paid 62% more for the death benefit than you would have with a Canadian policy. If the policy had a cash value the same would apply to any taxes on the increase in the value of the policy. Bear in mind, that with a Canadian policy with a cash value no tax would be payable.

The last point to bear in mind is the creditworthiness of the insurance company. In Canada, life insurance companies are stringently regulated. A life insurance company authorized to sell insurance policies in Canada is required, by the federal, provincial and territorial regulators, to become a member of Assuris. Assuris protects all benefits under policies issued in Canada by a member Company to a Canadian citizen or resident. Rather than cancelling the policy and paying cash compensation, Assuris protects policyholders by facilitating the transfer of policies to a solvent company and ensuring the continuity of covered benefits under the original terms of the policy. If a life insurance company fails, Assuris guarantees that on transfer, policyholders will retain at least 85% of the promised insurance benefits. Insurance benefits include death, health Expense, monthly Income and cash value.

When buying a policy from an offshore insurance company the onus is on you to determine how financially viable the company is. You can check the rating of the company with a rating service such as Standard & Poor’s. The rating applies to the company’s current status and attempts to take into account the company’s future financial results. If the insurance company fails, there is no organization that guarantees any of the benefits and you could have no policy, no cash value and lost all the premiums that you paid.

To sum up the disadvantages are numerous.

• The cost of applying for, and receiving the policy outside Canada.
• Tax that has to be paid on the increase in value of a life insurance policy with a cash value.
• Exposure to fluctuation of the exchange rate between the Canadian and US dollar
• Credit worthiness of the offshore life insurance company that could result in the loss of the policy, cash value  and all premiums paid.

According to Richard Segal, author of the MTAR chapter in the LexisNexis’ (2013) recently released book, ASK: Advisor’s Seeking Knowledge – A Comprehensive Guild to Succession and Estate Planning, clients considering offshore insurance have a better Canadian alternative available to them. Richard in his chapter presents the benefits of the Canadian alternative providing the client with the following outcomes:

• Your money would stay in Canada, where you can see it, touch it, feel it and smell it.
• Your policy would be Income Tax Act MTAR compliant.
• Corporate deposits can be structured to be deductible.
• All personal deposits can be structured to be deductible over time.
• Large annual deductions are provided each year against income for the rest of your life.
• Money would be invested on a deductible basis, so the money grows tax-free. The individual retires tax-free, dies tax-free, and all the while having savings protected from creditors.
• The corporate or personal deduction creates a cash-on-cash return every year, year in and year out, in a plan where tax will never be paid as you use the funds for either retirement or investing.

Thoughts to consider the next time your client is pitched an offshore life insurance policy. This was what Michael Cadesky meant by his statement: “There appears to be a great mystique attached to offshore life insurance policies being promoted to ultra-wealthy Canadians but there is more to this than meets the eye.”