March 1, 2009

10-8 Leveraging: Are Tax Audits on the Way?

Did they get you to trade
your heroes for ghosts?
Hot ashes for trees?
Hot air for a cool breeze?
--- Pink Floyd, Wish You Were Here

Tax advice and income tax strategies. That's #1 on the list of what the wealthy demand from their trusted financial advisors. You're looking for more aggressive recommendations. That doesn't mean you'll blindly act on every idea. You'll weigh the risks and rewards.

But how can you decide what you want until you know what's available?

Fight or Flight?
Cold comfort for change?
Did you exchange a walk-on part in the war for a lead role in a cage?
--- Pink Floyd, Wish You Were Here
Flight: If you're very risk averse, that's fine. You can hide in the shadows by simply paying more tax than necessary. Even then, the taxman may still seek you out: to thank you for being such a profitable customer.

Fight: Successful tax planning leaves more of what you earn with you --- where it belongs. There's more risk, though. You could get audited. That scares some. Others simply factor that possibility into their risk/reward calculus.

CRA Audits of 10-8 Leveraging (or 10/8, 8/10 and 8-10)?

"The Canada Revenue Agency has recently become aware of these loan arrangements and we are reviewing them to ensure they comply with the Income Tax Act." --- Rebecca Merrett, Communications Manager
Since early December 2008, there's been concern about potential audits of 10-8 insured leveraging strategies by the Canada Revenue Agency (CRA). These strategies --- the last major innovation in insured tax planning --- turbocharge the perennial top 5 insured strategies by adding the advantages of financial leveraging while reducing the risks. And creating tax deductions.

In brief, you put cash into a special universal life policy. This creates collateral. You borrow at 10% and invest in suitable investments. This makes the loan interest tax-deductible, which drops your after-tax loan cost to 5%-6% (depending on your tax rate). What happens to your collateral? As a reward for borrowing, your collateral grows at 8% in a tax-sheltered environment. My American Express card rebates 0.5% for borrowing at 10.99% (current rate, conditions apply). Other lenders give points or other incentives.

You can invest with a line of credit secured against your house, but with 10-8 leveraging
  • your loan rate is 10% (meaning larger deductions than borrowing at bank prime rates)
  • your collateral grows at 8% tax sheltered (house prices can drop)
  • you get life insurance
What Might Concern CRA?
CRA looks for abuse of the tax system. And they look for revenue. Since tax deductions decrease tax revenue, CRA may have concerns. Here are the three most likely areas:
  • Is there a reasonable expectation of profit from the investments made?
  • Is 10% a reasonable loan rate? (Dell's current flyer shows rates of 9.99% to 28.99%)
  • Does the General Anti-Avoidance Rule (GAAR) apply? (A somewhat arbitrary "smell test")
You can find out more via the links at the bottom of this post.

There's plenty of noise about what CRA may do.
Running over the same old ground.
What have you found?
The same old fears.
--- Pink Floyd, Wish You Were Here
Those who oppose or don't have access to 10-8 strategies are spreading fear. Those who never understood 10-8, have moved to the sidelines --- where they belong. Those who did their due diligence at the outset remain in the game unfazed.

Time To Panic?
That's your call. Do consider the following facts:
  • when uncertain, insurers get (expensive) independent outside tax opinions before developing new strategies
  • 10-8 leveraging has been around for most of this decade
  • most major insurers offer 10-8 strategies: BMO [bought AIG], Industrial Alliance, RBC, Sun, Transamerica
  • there are no known challenges from CRA
  • major accounting firms have reviewed and approved 10-8 strategies for their clients
  • no insurer has discontinued their 10-8 strategies
  • no major distributor has suspended the marketing of 10-8 strategies
The Worst Case
Suppose CRA finds fault with 10-8 leveraging. What happens? You can expect insurers to defend their positions and accounting firms to defend their clients. The courts would ultimately decide.

In the worst case, the loan interest would not be tax deductible. You would have borrowed at 10% to earn 8% in a tax-sheltered environment. That's not the worst thing in the world. You can unwind the leveraging by repaying the loans by selling the investments made with the borrowed money. You're then left with a "normal" universal life insurance policy. That's not so bad either.

Independent Opinion
Before embarking on any tax strategy, you know enough to get independent advice from professionals with relevant experience. Right? Note the work "relevant". Skills vary. Areas of expertise vary. So do levels of competence, but this is harder to spot unless you're an insider.

I'm biased. The wealthy want aggressive tax strategies to deal with their tax burdens. I was glad to help as the product actuary for one of the first insurers to offer 10-8 leveraging in Canada. Today as a marketing actuary, I spend most of my time helping advisors bring 10-8 leveraging to their clients.

There's fog today but won't the sun rise tomorrow? Won't the wind blow through the trees? Won't hot air give way to a cool breeze? As the old fears disappear. Wish you were here.




Thicken My Wallet said...

On a practical basis, I am not sure it is such a wise move to take on the resources of the insurance industry.

...but if audit risk puts the retail investor on the sidelines, then CRA probably is getting the result it wants.

Thomas McDorrgett said...

The number of tax scams out there grows each and every year. There are cons out there that are out to achieve as much details as they can from you so they can report taxes as you and claim your rebate. What's even scarier is that all these crooks require is a computer and a database of email addresses. The prey hardly ever comes in contact with the con hence why it is grueling to follow where or when the information was stolen. Acquire the facts to stay safe this tax time of year.

Martin Devaughn said...

Comprehending which tax laws are at this time in place is complicated, due to all the tax debates in Washington. I found this site that discusses which biggest tax laws are active for the 2012 tax time. I believe this will help others as much as it has helped me organize my taxes.

Chase Howard said...

Thanks for sharing this! Whenever I was in doubt of anything, I always turned to IRS tax services to make sure I was going to do everything right. They really helped me out during the last tax season, and I was actually wondering if there is any new info about this since it was posted?