When is interest deductibility available in “corporate borrowing” CIRP scenarios?
The Corporate Insured Retirement program (CIRP) is an attractive planning tool. It’s one of the most popular concepts in the insurance industry. It involves assigning a cash-value permanent life insurance policy as collateral security to a bank and in turn, the bank lending funds directly to either (1) the corporation tax-free, followed by taxable dividends to the shareholder, or (2) the shareholder (personally) tax-free. For a more in-depth discussion on the difference between corporate and shareholder (personal borrowing), please refer to my 2-part article on this topic referenced in the footnote below. The purpose of the borrowed funds is generally to support the shareholder’s retirement lifestyle goals. Although the need to access cash values may not occur for quite some time, the importance of demonstrating this feature at the time of sale is often paramount to making the sale. It’s here where advisors are asked to run a retirement scenario based on many assumptions including whether to illustrate corporate or shareholder (personal) borrowing. At face value, corporate borrowing comes out less attractive than personal (shareholder borrowing) since funds, although received tax-free by the corporation, are eventually paid out as taxable dividends to the shareholder. Leaving less money for the shareholder to spend during their retirement years. One of the many options (assumptions) most often misunderstood and overlooked by advisors, which can also tip the conversation in favor of the corporate borrowing scenario with all its simplicity, is whether “interest” on the loan is deductible. In this article, I’ll explore how CRA defines interest deductibility and how the “fill the hole” technique may be utilized in the corporate borrowing scenario to help qualify for interest deductibility.
How does CRA define interest deductibility:
Interest on loans is deductible if borrowed funds are used to generate income from business or property. Income refers to things like interest, rents, royalties, business income or trading gains. It doesn’t include capital gains. If borrowed funds are used to invest in portfolios that only earn capital gains, they will not earn income and therefore the interest on those borrowed funds are not deductible. In situations where the investment's primary objective is capital growth, it is possible to deduct interest as long as there is an expectation to earn income (i.e. interest or dividends). So, if borrowed funds are used to supplement retirement (or personal ) lifestyle goals…it’s not deductible. Is there another way?
“Fill the Hole”
If the corporation is borrowing and using the funds to pay a dividend or to redeem shares, CRA allows interest deductibility if the borrowed funds are used to “FILL THE HOLE” created by removing the capital in the corporation. In other words, the money borrowed to pay the dividend does not exceed the capital before it was distributed. Capital for this purpose generally includes contributed capital and accumulated profits. Even though funds are eventually used for the shareholder’s personal lifestyle goals, the interest can be deductible in this corporate borrowing scenario.
This can be better understood with an example. Let’s say that a corporation had an investment portfolio worth $2 Mill. (capital), in addition to a cash-value permanent life insurance policy. The time came to extract funds to supplement the shareholder’s retirement income (paid out as a taxable dividend to the shareholder). The corporation can either decide to withdraw funds from the investment portfolio or borrow funds (corporate borrowing) from the life insurance policy (as a collateral loan). Either option is available. Instead of going through the trouble of withdrawing funds from the investment portfolio only to make it ‘whole’ again by replenishing it with borrowed funds (via an investment line of credit), the corporation can simply use the life insurance policy as collateral and avoid these steps, altogether. In both scenarios, the interest is deductible. It simply saves a few steps. The question then becomes, can the corporation take advantage of the interest deduction? Will the corporation generate taxable income from other investments/business (capital) to use the deduction against?
To ensure interest deduction is available for the duration of the corporate borrowing scenario, two points need to be considered:
the corporation must have capital greater or equal to the collateral loan outstanding on the life insurance policy. Capital that earns taxable income (business/investment).
it’s important to pay the loan interest out of pocket each year. If cash is not available, assets that generate income could be sold, and the proceeds from the sale used to pay the loan interest. Then a new loan can be arranged (equal to the cash utilized to pay the interest), and the loan proceeds can be used to repurchase the assets. Since the new loan is used to purchase an income-earning property, interest on the loan should be deductible annually. The same series of steps would need to occur each year to avoid compound interest.
Corporate Insured Retirement Plan (case study):
Here’s an example of a Corporate Insured Retirement Plan (CIRP) comparing two “corporate borrowing” scenarios (1) with interest deductibility and (2) without interest deductibility, for a male and female age 47 (joint last to die) committing $50K per year for 10 years to a Sunlife Par Protector Life with max Plus Premium (current 2023 dividend scale interest rates). This is also assuming the top corporate and personal tax rates in Ontario…retirement income starting at age 65 for a duration of 25 years, and 90% loan/CSV ratio and life expectancy to age 90. Based on these assumptions, and being able to deduct interest, they can receive an additional $12,753 ($40,618 minus $27,865) or 47% more in after-tax cash flow per year during their retirement (see table below). This is a significant difference and worth exploring.
In the shareholder (personal) borrowing scenario, interest deductibility is only available if funds are used for investments/business purposes and not for personal lifestyle goals. With corporate borrowing, what the shareholder does with the dividends received does not impact interest deductibility and can also be less complicated than shareholder (personal ) borrowing. Unlike the shareholder (personal) borrowing option, corporate borrowing doesn’t involve issues at the time of borrowing (the need for the shareholder to pay a guarantee fee) nor issues at the time of death (the need for the executor to arrange an alternative security to the outstanding loan, instead of the corporately owned life insurance policy). Assuming the scenario where funds are needed for personal lifestyle goals, corporate borrowing with payment of dividends to the shareholder “with interest deductibility” can be a viable alternative and one worth exploring.
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