Principal Issues: Is the interest on a policy loan from a universal life policy of a life insurer deductible under paragraph 20(1)(c) of the Act?
Position: General comments only.
Reasons: Specific product.
XXXXXXXXXX 2004-006553
December 6, 2004
Dear XXXXXXXXXX:
Re: Interest Deductibility
We are writing further to your request for our views on the deductibility of interest paid on certain universal life policy loans.
Under a typical UL policy the policyholder has the contractual right to borrow against the account value by way of a policy loan. You indicate that one way this might be accomplished is to move the amount borrowed from the investment account to a loan collateral account. The insurer will credit the policyholder with interest on the amount transferred to the loan collateral account but will maintain a forced spread between this rate and the rate it charges on the policy loan. The interest rate on the loan may be specific in the policy and would normally reflect a competitive interest rate. By way of example you indicated that if the insurer required a 2% spread and the commercial borrowing rate was 5%, 3% would be credited to the loan collateral account.
You have requested our views with regard to the deductibility of interest if the insurer were to issue a policy that maintained its 2% spread but charged the policyholder interest of 10% on the policy loan and credited 8% to the loan collateral account.
Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an Advance Income Tax Ruling request. Where the particular transactions are completed, the inquiry should be addressed to the relevant Tax Services Office. However, we are prepared to provide the following general comments.
Clearly the intent of the increased rates is to attempt to provide the policyholder with an increased deduction for interest under paragraph 20(1)(c) of the Act and an increased return under the policy on tax deferred or the exempt basis. However, in order for interest to be deductible under paragraph 20(1)(c) of the Act, the amount of interest that has been paid or is payable must be reasonable in the circumstances. Of relevance in determining whether the interest rate is reasonable would be comparisons to the rate of interest being charged for policy loans under UL policies that do not offer the stepped up rate and the rate of interest that is being charged by other lenders with similar credit ratings.
Apart from the issue of reasonableness, as it would seem that this type of arrangement is not in accord with the purpose and spirit of the provisions in the Act related to exempt insurance policies we have referred this matter to the Department of Finance for their consideration.
Yours truly,
F. Lee Workman
Financial Institutions Team
Income Tax Rulings Directorate
Policy & Planning Branch
c.c.: Denis Normand Department of Finance