CLHIA Comments on Proposed Draft Legislation: “Synthetic Equity Arrangements”Release Date: 10/02/2015 Staff Reference: Noeline Simon
October 2, 2015
90 Elgin Street
Attention: Pascale Dugré-Sasseville
Chief, Financial Institutions Taxation
Business Income Tax Division, Tax Policy Branch
Dear Ms. Dugré-Sasseville:
Re: Proposed Draft Legislation: “Synthetic Equity Arrangements”
We are writing to you in connection with the April 2015 Federal Budget which included proposals to amend the Income Tax Act (Canada) with respect to “synthetic equity arrangements” (the SEA proposals) and the July 2015 draft legislation which would implement the SEA proposals.
The purpose of this letter is to ask that the SEA proposals be clarified or narrowed to preclude any risk of an unintended and inappropriate application of those rules to life insurance policies. In particular, as discussed below, we submit that life insurance policies do not raise the concern (described in the April 21, 2015 Budget materials) which prompted the SEA proposals:
“Synthetic equity arrangements entered into with certain investors that do not pay any Canadian income tax on the dividend-equivalent payments received – namely tax-exempt Canadian entities and non-resident persons (collectively, “tax-indifferent investors”) – have the potential to significantly erode the Canadian tax base.”
Accordingly, we submit that the SEA proposals should be clarified or narrowed so that they do not apply to life insurance policies.
Established in 1894, the Canadian Life and Health Insurance Association (CLHIA) represents life and health insurance providers accounting for 99% of the business in Canada. The Canadian life and health insurance industry plays a key role in Canada’s economy. It protects over 75% of Canadians through a wide variety of life and health insurance and annuity products. The industry paid over $83 billion in benefits in 2014 or more than $1.6 billion a week, with over 90% paid to living policyholders. Almost 155,000 Canadians earn some or all of their income directly from the industry (as employees or independent agents). The industry is a major investor in Canada with more than $721 billion in assets; nearly 90% of these comprise long-term investments, an important source of long-term capital for the federal and provincial governments and businesses. Canadian life insurers contributed over $1 billion in corporate income, capital, sales and other taxes to the federal government for 2014, including over $160 million of Part XII.3 Investment Income Tax. Canada’s life insurers have a longstanding record of operating in international markets, with almost $62 billion (or 41%) of their worldwide premiums from outside Canada.
Equity Based Life Insurance Policies
Most life insurance policies have an inherent savings element that arises from their typically level premium funding pattern. While the insurer may hold fixed income securities to support their obligations to policyholders, the insurer may also choose to hold equities, even where the returns available to policyholders do not vary based on the performance of equity investments. Internal and external risk and asset/liability management requirements/limitations can influence an insurers’ choice of investments.
Not all life insurance policies fully transfer both mortality and investment risk to the insurance company, and some policyholders demand greater flexibility in the investment risks they are prepared to assume within their life insurance policies. In the course of their Canadian life insurance business, many life insurers issue life insurance policies that are not segregated fund policies but which, nonetheless, have cash surrender values and insurance benefits that depend, in part, on the values of certain assets, such as government bonds, shares or units of mutual funds. The policyholder may select the underlying investments from a range of investment options offered by the insurer, and such options are generally subject to contractually guaranteed benefits payable on a surrender or maturity of the insurance policy. For some such policies (“equity based insurance policies”), the relevant assets may include shares of Canadian corporations and/or units of a mutual fund that holds shares of Canadian corporations (including an index fund where the index reflects the value of a basket of shares of corporations and more than 5% of the value of that basket reflects the value of shares of Canadian corporations).
In such situations, although the life insurer is not obliged to do so under the terms of the insurance policy, the insurer may hold the relevant shares or units for the purpose of matching its liabilities under the equity based insurance policies. Hence, the life insurer is very likely to receive dividends from the relevant shares and units held in connection with its equity based insurance policies.
From a policyholder’s perspective, the main purpose in obtaining life insurance is to mitigate the financial costs and obligations arising upon death of the insured. Any investment options within any life insurance policy are therefore of secondary concern.
Similarly, the life insurer’s main purpose in issuing an equity based insurance policy is to provide financial protection to its customers, not to enable the life insurer to receive dividends as the owner of those shares or units. This would generally be the case even if the effect of the insurance policy is that the life insurer does not bear the risk of loss nor enjoy the opportunity for gain or profit with respect to the relevant shares or units in any material respect. Where the main purpose of issuing the equity based insurance policy is not to enable the receipt of the dividends by the life insurer, it is generally considered, apart from the SEA proposals, that the dividends received by the life insurer on the relevant shares or units may be deducted under subsections 112(1) or (2) or 138(6) of the Act – that is, the “dividend rental arrangement” rules in the Act (as now in force) generally do not apply to deny the deduction because the requisite “main purpose” condition for their application is not satisfied.
The SEA Proposals
We submit that the SEA proposals were not intended to, but could, affect life insurers, after October 2015, with respect to their investments supporting equity based life insurance policies that are not segregated fund policies if the policyholder is a “tax-indifferent investor” (as defined in the draft legislation).
The SEA proposals will amend the “dividend rental arrangement” definition to include a “synthetic equity arrangement.” However, the proposals define a “synthetic equity arrangement” based on an “effects” test which looks to whether the effect of the arrangement is to provide (or transfer) all or substantially all of the risk of loss and opportunity for gain or profit on shares of Canadian corporations to a counterparty to the arrangement – and there is no “main purpose” test with respect to the receipt of dividends on such shares in the case of a synthetic equity arrangement.
Although the main purpose of issuing the equity based insurance policy is not to enable the receipt of the dividends by the life insurer, if the life insurer owns the relevant shares or units to match its obligations under an equity based insurance policy, the life insurance policy could be considered to satisfy the “effects” test if the policy has the effect of providing (or transferring) all or substantially all of the risk of loss and opportunity for gain or profit (including any dividends or distributions) in respect of the relevant shares or units to the policyholder. Although contractually guaranteed benefits payable on a surrender or maturity of the insurance policy may mean that the “effects” test is not satisfied in many cases, there may be some uncertainty in that regard, depending on the circumstances (such as market conditions) prevailing at the particular time and the actual terms and conditions of such guarantees. Accordingly, under the Budget proposals, an equity based insurance policy could be considered to be a synthetic equity arrangement, and to be a dividend rental arrangement, depending upon its particular terms and conditions and the prevailing circumstances. This creates an unnecessary risk of the SEA proposals applying to such life insurance policies.
Under the SEA proposals, the “dividend rental arrangement” rules will only apply to deny the deduction under subsections 112(1) or (2) or 138(6) of the Act for dividends received by the insurer on the relevant shares and units if the policyholder is a “tax-indifferent investor”. In general terms, a policyholder would be a “tax-indifferent investor” if the policyholder is, among other persons:
(i) a person who is exempt from tax under section 149 of the Act (for example, a registered pension plan trust, a RRSP, a DPSP, a RRIF, a RESP, a RDSP, a TFSA, an EPSP, a RCA), or
(ii) a non-resident person who does not hold the insurance policy as part of a business carried on in Canada through a permanent establishment in Canada (even if the policyholder was, at the time the insurance policy was issued, a Canadian resident).
The CLHIA submits that the SEA proposals are overly broad and should be clarified or narrowed to preclude their application to life insurance policies. Instead, arrangements involving life insurance policies should, if at all, continue to be subject to the existing “dividend rental arrangement” rules if they satisfy the requisite “main purpose” test under those rules.
In particular, the CLHIA requests that the meaning of a “synthetic equity arrangement” be clarified or narrowed by excluding a “life insurance policy in Canada” (as defined in subsection 248(1) of the Act) for the following reasons:
• An “effects” test is inappropriate for life insurance policies. We understand that an “effects” test may be desirable in circumstances where it is difficult to establish the main purpose of an arrangement and the potential loss of tax revenue is significant relative to compliance and enforcement costs. However, such a test is inappropriate for life insurance policies because:
o A policyholder’s decision to acquire an equity-based life insurance policy (and an insurer’s purpose of issuing the policy) is never for the purpose of enabling the receipt of dividends by the life insurer.
o Similarly, a policyholder’s decision to specify the underlying investments under an equity-based life insurance policy is never for the purpose of enabling the receipt of dividends by the life insurer.
o The Budget materials acknowledge that, depending upon the particular facts, arrangements caught by the SEA proposals could be challenged under the existing rules in the Act and that the SEA proposals were introduced to avoid costly and time-consuming challenges. However, any arrangements involving life insurance policies which satisfy the requisite “main purpose” test would be extremely rare (if at all), and it should therefore not be costly or time-consuming to challenge them under the existing “dividend rental arrangement” rules.
In the alternative, if the meaning of “synthetic equity arrangement” is not narrowed as requested, the meaning of “tax-indifferent investor” should be narrowed to exclude a policyholder of a “life insurance policy in Canada” because:
• A “life insurance policy in Canada” (or its policyholder in respect of the policy) is generally subject to a tax under the Act, and its policyholder should not be considered to be a “tax-indifferent investor”:
o If the policy is an “exempt policy” and is not a “registered life insurance policy” for the purposes of Part XII.3 of the Act, the life insurer is subject to the “investment income tax” under that Part annually and, in any case, if the policyholder terminates the policy other than due to death, any gain is generally subject to tax as ordinary income under section 148 of the Act.
o If the policy is not an “exempt policy” and is not itself registered as an RRSP, RRIF or TFSA, the policyholder is taxable on an accrual basis under section 12.2 of the Act, and, in any case, if the policyholder terminates the policy other than due to death, any remaining gain is generally subject to tax as ordinary income under section 148 of the Act.
o In any other case, the tax treatment of a “life insurance policy in Canada” is prescribed by a detailed set of rules and should not be overridden by the SEA proposals.
o A holder who acquires a “life insurance policy in Canada” continues to be taxable in Canada in respect of that policy even if the holder subsequently becomes a non-resident. Such a holder should not be considered to be a “tax-indifferent investor”.
• Other situations in which a “life insurance policy in Canada” might be considered to be a “synthetic equity arrangement” that is held by a “tax-indifferent investor” are extremely rare (if, in fact, any such situations might exist) and will make compliance both difficult and costly relative to the tax revenue gained:
o Very few equity-based life insurance policies are issued or effected as or under a tax exempt arrangement (for example, a registered pension plan trust, a RRSP, a DPSP, a RRIF, a RESP, a RDSP, a TFSA, an EPSP, or a RCA). As noted earlier, the acquisition of such a policy, including the choice of underlying investments, by the policyholder is never for the purpose of enabling the receipt of dividends by the life insurer.
o As noted earlier, a holder who acquires a “life insurance policy in Canada” continues to be taxable in Canada in respect of that policy even if the holder subsequently becomes a non-resident, and such a holder should not be considered to be a “tax-indifferent investor”.
The Act currently incorporates a detailed and specific regime applicable to life insurers, life insurance policies, and policyholders of such policies. Given that specific regime and the existing “dividend rental arrangement” rules in the Act, the CLHIA submits that applying the SEA proposals to life insurance policies would be inappropriate, is unnecessary and will lead to costly compliance burdens that are not likely to generate any material tax revenues.
Accordingly, we respectfully request that the SEA proposals be clarified or narrowed as described in this letter.
The CLHIA appreciates the opportunity to make these submissions. We are available to discuss these matters with the Department and to provide any additional information that would be helpful.
Original signed by
Vice President, Taxation and Industry Analytics