Immediate financing arrangement

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No price appears on this page, and none is sent by email. What a contract costs depends on the person and the design, and no honest figure can be produced from three answers.

What has to be true before this fits anyone

• There must be capital that would have been committed anywayThe arrangement redirects money that already had a job. It does not create capacity that was not there.
• A lender has to agree, and can change its mindLending against a contract is a separate agreement with its own terms, its own review, and its own conditions for calling the loan.
• Interest is a real cost and does not disappearThe arrangement changes who receives the interest and what the capital is doing meanwhile. It does not remove the cost of borrowing.
• The tax treatment is specific and it is not automaticDeductibility, the corporate account treatment and the position at death all turn on how the arrangement is structured and documented.

What an immediate financing arrangement actually is

An immediate financing arrangement is a structure rather than a product. No company issues one. It is assembled out of three separate things that already exist on their own: a permanent life insurance contract issued by an insurer, a loan from a lending institution, and a collateral assignment of that contract to that institution as security for the loan.

The sequence gives the structure its name. A person or a company applies for permanent insurance, is underwritten, is issued a contract, and funds it. The contract is then assigned to a lending institution, which advances a portion of its value as a loan, and the capital that went into the contract comes back out and is redeployed into whatever it was going to fund anyway.

That is the whole of the idea, and a presentation will describe it as putting your capital in two places at once. That phrase hides something, and what it hides is the loan. The capital is in one place, inside the insurance contract. What is in the second place is borrowed money, which carries interest, has to be serviced, is repayable, and belongs to a lending institution until it is repaid.

None of that makes the structure wrong. It makes it a structure with a lender inside it, and the lending has to be read as carefully as the insurance. The arrangements that end badly are almost never the ones where the owner understood the loan.

The sentence that governs everything below it

Before any of the mechanics, one sentence governs this page. The insurance contract has to be worth owning on its own terms first, before any financing is arranged around it.

Ask the questions in that order and most bad arrangements never get built. Is there a permanent insurance need here that would exist if no lender were ever involved? A tax liability that lands at death, a buy and sell obligation between shareholders, a family or a corporation short of capital at the worst possible moment. If the answer is no, the financing has nothing to attach to.

If the answer is yes, then the contract is chosen the way any permanent contract is chosen. Our pages on permanent life insurance, whole life insurance and universal life insurance set out how those contracts differ, and the contracts built for this kind of strategy explains why the funding pattern of a contract, not its name, is what makes it usable as security at all.

One consequence follows immediately. A contract with little or no accessible value inside it is not security a lending institution will advance against, which is why a term to 100 contract generally has no place in this structure even though it is permanent insurance. Permanence is not the qualifying feature. Value inside the contract is.

The mechanism, step by step

First, the insurance. A person or a company applies for a permanent contract, goes through underwriting, and is issued a policy. Nothing about this step differs from buying permanent insurance with no financing anywhere near it, and that is the point of it.

Second, the funding. The owner pays the premium, usually concentrated in the early years, because a contract holding value sooner is a contract an institution will lend against sooner. The funding pattern has to stay inside the limits that keep the contract an exempt policy, which is determined under section 306 of the Income Tax Regulations, depends on the specific facts, and goes to a qualified tax professional before anything is signed.

Third, the assignment. The owner signs a collateral assignment in favour of a lending institution and the insurer records it. The owner still owns the contract. The institution now holds a registered interest in it, and while the assignment stands the owner cannot deal with the contract freely: not the beneficiary designation, not a withdrawal, not a surrender, not a change of ownership, without the institution agreeing.

Fourth, the loan. The institution advances a portion of the value of the contract. The money is released to the borrower and is put to the use the borrower described when the facility was applied for.

Fifth, the servicing. Interest accrues on the balance, and depending on the facility the borrower pays it or it is added to what is owed. Where it is added, the balance grows every year without anybody writing a cheque.

Sixth, the review. The institution reviews the facility on its own schedule, commonly once a year, against the value of the contract and against the borrower at that time.

Seventh, the end. At death the insurer pays the proceeds of the contract. The outstanding loan and the accrued interest are repaid to the institution out of those proceeds. Only what remains after that goes to the beneficiary, to the estate, or to the corporation.

The lender is a third party and it makes its own decision

The lending institution is not the insurer, is not the person who presented the structure, and is not a party to the insurance contract. It is a separate organisation making a credit decision about a borrower, and it applies its own lending criteria to that decision the way it would to any other loan.

That means the arrangement has a second approval in it that nothing in the insurance process controls. The insurance can be issued exactly as illustrated and the credit facility can still be declined, reduced, or offered on terms the presentation did not contemplate. A structure sold as one decision is two, taken by two organisations on two sets of criteria.

The institution lends only a portion of the value of the contract, never all of it. The size of that portion, the interest rate, the security it requires, the covenants, the fees and the conditions of the facility are set by the institution and not by the insurer, not by the owner, and not by whoever drew the diagram.

And they are reviewed. A facility of this kind is typically reviewed periodically, often annually, and the terms on review are the terms the institution is prepared to offer at that time, in the conditions of that time, to that borrower. Nothing in a lending arrangement is fixed because the insurance contract is a long term one.

This is not a policy loan from the insurer, and the difference matters

Two different things are both called borrowing against a policy, and confusing them is the most consequential mistake a reader of this page can make.

A policy loan is an advance made by the insurer itself, out of the contract, under the terms of the contract. A collateral loan is money advanced by a separate lending institution under a separate credit agreement, with the contract pledged as security. Same feeling, different instruments, different tax treatment.

A policy loan from the insurer is a disposition under section 148 of the Income Tax Act, and where the amount advanced exceeds the adjusted cost basis of the contract the excess can produce a policy gain included in income. A collateral loan from a lending institution is generally not a disposition, because the contract has been pledged rather than dealt with. That is the structural reason the collateral route exists. It depends on the specific facts and goes to a qualified tax professional before anything is signed.

The adjusted cost basis is therefore a number the owner should watch, because it moves over the life of a contract and it is the reference point for anything that is a disposition. The Canada Revenue Agency bulletin IT-87R2 addresses policyholder income from life insurance contracts, and how it applies to a particular contract depends on the specific facts and goes to a qualified tax professional before anything is signed.

One further point belongs here, because it is the reason the structure has an ending. A death benefit paid to a named beneficiary is generally received free of income tax, because a payment made in consequence of death is excluded from the definition of disposition in subsection 148(9) of the Income Tax Act. That is a general statement of the rule, it depends on the specific facts, and it goes to a qualified tax professional before anything is signed.

Interest rates move, and the arrangement has to survive one nobody planned

Every one of these arrangements is presented with an assumed cost of borrowing in it. That assumption is the single most fragile input in the whole presentation, because it is the one thing in the structure that belongs to neither the insurer nor the owner.

Rates move. They have moved a long way inside the lifetime of arrangements that are still running today. An owner who signed when borrowing was cheap and is servicing that same balance in a period when it is not is carrying a cost that no insurance contract adjusts to offset. The contract does what it was always going to do. The loan does something else.

The honest test is not whether the arrangement works at the rate in the illustration. It is whether it still works at a rate the borrower did not plan for, sustained for years rather than months. If the structure only survives at the assumed rate, it is a rate bet with an insurance contract attached to it.

The related question is where the interest comes from. Interest paid out of operating income is a real reduction in what the business has. Interest capitalised into the loan is an obligation deferred and enlarged rather than avoided, and for several years nothing appears to be happening.

The risk that actually ends these arrangements

The end of a troubled immediate financing arrangement is usually not a death, a tax reassessment or a lapsed contract. It is a letter from the lending institution.

A facility secured by a contract is sized against the value of that contract. If the relationship between what is owed and what secures it moves against the borrower, because the balance has grown with capitalised interest or because the institution has changed how it looks at the security, the institution can require additional security, reduce the facility, decline to renew, or call for repayment.

That is the risk that ends these arrangements, and it arrives at a borrower who has already redeployed the money. The capital that came out of the contract is in a building, a business, a project or a portfolio. It is not sitting in an account waiting for a demand. A borrower who has to produce liquidity quickly, on somebody else’s timetable, in conditions bad enough to have prompted the review, is a borrower in real difficulty.

There is a quieter version of this. Where the only way out is the contract itself, the owner collapses the insurance to settle the loan. That can be a disposition with tax consequences of its own, and it destroys the protection the family or the corporation bought, at an age when replacing it is harder. The tax treatment depends on the specific facts and goes to a qualified tax professional before anything is signed.

The deductibility question, and where the answer has to come from

A presentation for this structure will usually show two deductions. One is the interest on the loan. The other is a portion of the premium. Both are real features of Canadian tax law in defined circumstances, and neither of them is a feature of the arrangement itself.

Interest deductibility turns on the use of the borrowed money. Money borrowed and used for the purpose of earning income from a business or from property is treated differently from money borrowed and used for something else, and the tracing of that use, on the actual facts, is what the analysis rests on. A diagram does not establish the use.

The deduction of a portion of the premium is narrower still. It is available in defined circumstances where a contract has been assigned to a restricted financial institution as security for a loan used to earn income, it is limited to a measure of the cost of the pure insurance element, and the conditions must be met each year.

The rules are in the Income Tax Act and the analysis is factual. The only responsible sentence a page like this one can write is the same sentence every other tax paragraph on this page ends with: it depends on the specific facts, and it must be confirmed by a qualified tax professional before anything is signed, rather than assumed from a presentation.

That is not a formality. If the arrangement only makes sense on the assumption that both deductions will be available for its whole life, it depends on an answer nobody in the room selling it can give.

The corporate version and the capital dividend account

Most of these arrangements are corporate, because most of the reasons to build one are corporate. A company with a permanent insurance need and a use for capital is the situation the structure was designed around, and the corporate version has one element the personal version does not.

When a private corporation receives the proceeds of a contract of which it is the beneficiary, a credit generally arises to its capital dividend account. Under paragraph (d) of the definition in subsection 89(1) of the Income Tax Act, that credit is the amount by which the proceeds exceed the adjusted cost basis of the policy to the corporation. It is the excess and not the whole, and a presentation showing the entire death benefit flowing out as a capital dividend has skipped that step.

The second corporate point gets left off diagrams. An outstanding loan is repaid before anything reaches the estate or the shareholders. The proceeds arrive, the lending institution is repaid what it is owed including accrued interest, and what is left goes to the family, the estate or the surviving shareholders. The purpose the insurance was bought for, whether that is liquidity at death or funding a shareholder agreement, is served by the remainder and not by the face amount.

That is not an argument against the corporate version. It is an argument for sizing the insurance around what has to be left after the loan is repaid, which is larger than the number a board usually starts with. How this works in a specific corporation depends on the specific facts and goes to a qualified tax professional before anything is signed.

A collateral loan, a policy loan and simply paying cash

Three ways to get at capital sit behind this page, and they are three different instruments with three different sets of consequences.

The column on the right gets the least attention and deserves more of it. Paying cash for the thing the capital was going to fund, and owning an insurance contract beside it that nobody has pledged, is a complete answer for many owners, and it fails in fewer ways.

The situation this structure was designed around

There is a profile the structure was built for, and describing it is not the same as saying that anybody reading this page is inside it.

It is a business owner or a professional corporation with a permanent insurance need that already exists on its own. It is an owner with a real and identifiable use for the capital, one that would have been funded anyway out of some other source. It is a borrower with the income to carry the loan without depending on anything the arrangement produces. And it is a file where a qualified tax professional and a lawyer or a notary are at the table before the application is signed, not brought in afterwards.

One more condition sits underneath those four. The owner has to be able to lose the financing entirely, on a review, and still be glad to hold the insurance contract. That is the practical form of the sentence at the top of this page.

Where a participating contract is used, the dividends that may be credited to it are declared annually at the discretion of the insurer and are not guaranteed, and an arrangement whose survival depends on them being credited at any particular level is an arrangement built on something nobody has promised. Our page on how participating contracts are used in a strategy goes through that in detail.

Who this is not for

Anybody who is buying it for the leverage rather than for the insurance. If the insurance would not be purchased on its own, then what is being bought is a loan wrapped in a contract that has costs of its own, and it will be judged against alternatives that do not carry those costs.

Anybody whose plan depends on a rate staying where it is. The cost of borrowing is set outside the arrangement, for the whole life of the arrangement, by parties who owe the borrower nothing.

Anybody who would be in difficulty if the lending institution changed its mind. That includes a borrower with no other liquidity, a borrower whose redeployed capital cannot be recovered quickly, and a borrower for whom collapsing the contract would be the only available answer.

And anybody who has been shown this structure with the word guaranteed used loosely, or with a phrase suggesting the capital is genuinely in two places at once and nothing said about the loan in the second place. A presentation that does not spend as long on the lender as on the insurance is not a presentation of this structure. Our page on how these strategies are mis-sold covers the language to watch for.

Four questions that would stop a bad arrangement

Would I buy this insurance contract if no financing existed at all, and can I say what need it answers in a sentence that has nothing to do with the loan?

Who is the lender, what are the terms of the facility in writing, how often is it reviewed, and what precisely can the institution do at a review?

What does this arrangement look like at a cost of borrowing well above the one in the illustration, sustained for years, and where does the money to carry it come from in that case?

Which qualified tax professional has looked at the deductibility of the interest and of the premium on my actual facts, and has that opinion been put in writing before anything is signed?

A promoter who answers all four plainly, in writing, is describing a real arrangement. One who moves the conversation back to the illustration is answering a different question.

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