Sovereign Assurance Company Ltd and Others v Commissioner of Inland Revenue

• Jurisdiction: New Zealand
• Judge: Harrison J
• Judgment Date: 17 December 2013
• Neutral Citation: [2013] NZCA 652
• Docket Number: CA506/2012
• Court: Court of Appeal
• Date: 17 December 2013

BETWEEN

Sovereign Assurance Company Limited

First Appellant

Asb Bank Limited

Second Appellant

Sovereign Services Limited

Third Appellant

Cba Asset Finance (Nz) Limited

Fourth Appellant

Cba Funding (Nz) Limited

Fifth Appellant

Cba Dairy Leasing Limited

Sixth Appellant

and

Commissioner of Inland Revenue

Respondent

[2013] NZCA 652

Court:

Harrison, White and Miller JJ

CA506/2012

IN THE COURT OF APPEAL OF NEW ZEALAND

Appeal from a High Court decision which held that commissions received and the base component of the commission repayments when paid were not respectively assessable income and deductible expenditure under the ordinary or non-accrual provisions of the Income Tax Act 1994 — appellant provided life insurance — it entered into a financial treaties with German reinsurers to gain financial assistance — under the treaty the reinsurers agreed to make advances to the appellant by paying commissions on policies ceded under the treaties; and the appellant agreed to pay the reinsurers commission repayments in amounts equal to the commission payments (the base component) plus an interest component (the excess component) — whether the commission payments made by the reinsurers constituted income or capital.

Counsel:

L M McKay and M McKay for Appellants

TD J Goddard, QC and H W Eberesohn for Respondent

A The appeal is dismissed.

B The appellants are to pay the respondent costs for a complex appeal on a band B basis and usual disbursements. We certify for two counsel.

JUDGMENT OF THE COURT

REASONS

Harrison and Miller JJ [1]

White J [128]

HARRISON AND MILLER JJ

(Given by Harrison J)

Table of Contents

	Para No
Introduction	[1]
Commercial context	[11]
Gerling reinsurance treaty	[22]
Article 1	[23]
Article 2	[24]
Articles 4 and 5	[26]
Article 9	[34]
Article 20	[35]
Article 21	[36]
Supplementary documents and agreements	[37]
Issue one: Accruals regime	[42]
Issue two: Legal nature of the base component – capital or revenue?	[61]
Principles	[63]
Contractual analysis	[71]
(a) Cession of shared mortality and persistency risks	[75]
(b) Finding of transfer of lapse risk	[84]
(c) Transfer of future cash flows	[88]
(d) Extreme lapse risk	[98]
(e) Original terms reinsurance	[104]
(f) Miscellaneous factors	[108]
Conclusion	[116]
Result	[126]

Introduction

1 In its formative years as a life insurer Sovereign Assurance Co Ltd needed two distinct types of financial assistance. The first was of a contingent but orthodox nature, to secure reinsurance against its risks on claims made under life policies. The company was able to satisfy this requirement by entering into treaties with well resourced reinsurers whereby it ceded or passed on most of its insured risks.

2 Sovereign was able through the same treaties to satisfy its second financial requirement – to fund its costs of establishing the policies. The parties employed a financing mechanism which was well established in the reinsurance industry. The reinsurers agreed to make advances to Sovereign by paying commissions on policies ceded under the treaties; and the company agreed to pay the reinsurers commission repayments in amounts equal to the commission payments (the base component) plus an interest component (the excess component).

3 What is at issue on this appeal is the correct taxation treatment of these reciprocal but unequal commission flows. To use Mr McKay's simple example, Sovereign assessed its taxation liability by treating (a) every $100 of commission received as income in the year of receipt; and (b) every $150 of commission repayments – that is, the aggregate of the base ($100) and excess ($50) components ߞ as deductible expenditure in the year of payment.

4 However, the Commissioner reassessed that liability for the 2000 to 2006 years. She treated Sovereign's $100 receipt as non-taxable and its payment of the equivalent $100 base component as non-deductible. By this means she effectively offset or disregarded the two commission flows to the extent that they were equal. As a result, only the remaining $50, the excess component, was allowed as a deductible expense.

5 Following a six week trial in the High Court, Dobson J agreed with the Commissioner. 1 His primary finding that the Commissioner was entitled to reassess

Sovereign's liability to tax under the accruals rules in subpt EH of the Income Tax Act 1994 (the ITA) is not challenged

6 Sovereign's appeal is limited to the Judge's subsequent findings that (a) the commissions when received and the base component of the commission repayments when paid were not respectively assessable income and deductible expenditure under the ordinary or non-accrual provisions of the ITA; and (b) both items were of a capital nature, with the result that the commissions were not earned as income on receipt. The focal point of Sovereign's argument on appeal was whether the latter finding was correct. While directly engaging on that argument, the Commissioner argues that Dobson J's finding that the accruals rules govern Sovereign's liability to tax is decisive against its appeal.

7 What, it may be rhetorically asked, does the dispute matter when on both approaches Sovereign was entitled to a net deduction against its liability to tax of $50? The issue is one of timing. If its challenge fails, Sovereign faces a potential liability of up to $90 million including use of money liability. The company was in a tax loss position before its acquisition by ASB Bank Ltd in December 1998. The effect of the Commissioner's reassessments is to reallocate and increase its losses in that period. Sovereign's change of ownership means that these losses are unavailable to shelter its increased liabilities to tax from 2000.

8 The fiscal effect of the Commissioner's reassessments is reflected by reference to Sovereign's liability to tax in two successive income years. In 2001 the Commissioner disallowed Sovereign's claim for deductions for commission repayments of $55.564 million and removed from the company's gross income commissions of $31.917 million, increasing the level of taxable income derived by $23.647 million. In 2002 the Commissioner disallowed Sovereign's claim for deductions of $38.223 million for commission repayments and removed commissions of -$1.773 million, increasing taxable income by $39.997 million.

9 Before addressing the merits of Sovereign's appeal we record some introductory points. One is that the focus of the company's objection to the Commissioner's reassessment has retrenched significantly following the abandonment of its primary challenge to the Commissioner's application of the accruals rules. In the result, what were relatively subsidiary questions before Dobson J are now at the forefront of Sovereign's appeal. Another is that the positions adopted by the parties before us are inconsistent with those adopted by each at earlier stages of the reassessment and disputes process; and also with the stances traditionally taken by the Commissioner and a taxpayer on disputes about whether an item is received or paid on capital or revenue account. And another is that we are required to determine this appeal primarily by reference to a contractual instrument drafted by actuaries steeped in insurance practice, not by lawyers, and originally recorded in the German language but later translated into English.

10 The treaties and supplementary instruments governed the relationship between Sovereign and its reinsurers and the character of the underlying financial transactions. The company's appeal against the finding that the commissions were of a capital rather than revenue character will be determined primarily by our construction of the provisions of what is agreed to be a representative treaty. For that reason, we shall first outline the factual or commercial matrix, before summarising the treaty's relevant terms and conditions, Dobson J's findings and the applicable legal principles. Our analysis will then follow.

Commercial context

11 There is no dispute about the relevant facts which are set out comprehensively in the High Court judgment. 2 They can be summarised more briefly for the purposes of this appeal as follows.

12 Sovereign was founded by Messrs Chris Coon and Ian Hendry and commenced business in New Zealand as a life insurer in 1989. Mr Coon had qualified as an actuary in the United Kingdom and had considerable life insurance experience. Sovereign was in immediate competition with more established players — either mutual life companies or United Kingdom owned proprietary companies which enjoyed significant capital reserves and stable portfolios of business.

13 As a new and privately owned company with relatively little capital, Sovereign faced three discrete financing strains. The first strain arose from a life insurer's core business of undertaking a liability to indemnify another party against the adverse financial consequences of a defined risk imposed through the medium of a policy of insurance. The defined or insured risk for a life insurer is the risk of mortality, or more particularly an obligation to make certain payments on the death of a life assured. 3 Life insurers frequently cover themselves against this contingent financial liability by transferring a large part of their legal obligations to well-resourced reinsurers. The cost of reinsuring is determined in accordance with the same pricing methodology which governs the original contract of insurance. Like the life assured, the insurer pays to the reinsurer a premium representing a price calculated by reference to the insured risk in return for the reinsurer's undertaking to meet its proportionate share of claims made against the insurer.

14 To give context to what follows, it is...