Sovereign Assurance Company Ltd and Others v Commissioner of Inland Revenue

JurisdictionNew Zealand
CourtCourt of Appeal
JudgeHarrison J
Judgment Date17 December 2013
Neutral Citation[2013] NZCA 652
Date17 December 2013
Docket NumberCA506/2012

[2013] NZCA 652

IN THE COURT OF APPEAL OF NEW ZEALAND

Court:

Harrison, White and Miller JJ

CA506/2012

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
Counsel:

L M McKay and M McKay for Appellants

TD J Goddard, QC and H W Eberesohn for Respondent

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.

The issue was whether the base commission repayments constituted income or capital.

Held (per Majority): The commission transactions fell within the broad definition of a financial arrangement under sEH14 ITA (definitions — financial arrangement means any debt and any arrangement where a person obtained money in consideration for a promise by any person to provide money to any person at some future time or times). The financing component of the treaty was an arrangement whereby Sovereign obtained money from the reinsurer (the commission payments) in consideration for promising to pay money in the future (the commission repayments). This element of deferred consideration was central to the rules. So too was the regime's inherent dilution of the orthodox distinction between capital and revenue, ensuring a neutral tax treatment regardless of form.

For the purpose of s EH 1 ITA (accruals in relation to income and expenditure in respect of financial arrangements), it could not be disputed that the commission cash flows were subject to the accruals regime for the purposes of calculating gross income or expenditure. In terms of sEH 1(1)(b) ITA, Sovereign was the issuing party for the financial arrangement. In calculating its gross income or expenditure the company was required to take into account, first, all amounts relating to the financial arrangement — that is the commission repayments spread over time (mortality risk reinsurance premiums which related to the contract of insurance were excluded) and, second, the acquisition price of the financial arrangement — all the commissions and other payments made by the reinsurers under the treaties (but again for the same reason excluding other receipts such as mortality claim payments).

Section EH 10(2) (EH 10 Relationship with rest of Act — Property transfer price) had no application as no property was in fact transferred. The purpose and scope of sEH 10(2) was to provide a mechanism that avoided double taxation (or double deductions) where an arrangement provided more than just financing because it also provided for the transfer of property.

The commission payments and repayments did not constitute an “excepted financial arrangement” as defined in sEH 14 ITA. In particular, the payments did not constitute a “contract of insurance. The payments were not excluded from the application of the accruals rules under sEH11 ITA (application of accrual rules).

The financing part of the treaty simply provided financing. In exchange for receipt of certain sums, the equivalent amount plus interest has to be repaid. The commission flows did not constitute a transfer of property so sEH 10(2) ITA (property to be treated for the purpose of any provision other than the qualified accruals rules as having been transferred under the financial arrangement for an amount equal to the acquisition price of the property) had no application as no property was in fact transferred. Sovereign had received the commission payments to fund its working capital costs and repaid the same amount plus interest.

The commission arrangements did not fall within an excepted category allowing for taxation consequences external to the accruals rules.

In order to qualify as deductible expenditure in terms of sBD 2(1)(b) ITA (allowable deductions — exclusions) Sovereign's base component commission repayments to the reinsurers had to be incurred in deriving its gross income and not be of a capital nature. In terms of the income tax legislation the treaties were contracts of reinsurance with a financing component. The consistent theme running through was of monies advanced to and repayable by an insurer for the purpose of financing its policy establishment costs. There was no agreement to share liability for Sovereign's lapse risk on ceded policies. The commission repayments were just as the parties described them — repayments of advances. They were priced separately from the risk premium payments by reference to the insurer's own proportionate allocation of the underlying premiums to its persistency risk.

What was ceded was a share of policy liabilities, not the policies themselves or the premium entitlements they carried. The consideration for the reinsurers agreement to pay commissions was Sovereign's promise to repay the same amounts with interest at a later date, not a promise to sell its stock in trade.

In a business and practical sense, the advances were not earned in the course of Sovereign's business as a life insurer. Sovereign's expenditure in the form of payments of the base component of the commission repayments was not incurred in deriving income. When the treaty including the termination provisions was read as a whole, the legal character of the commission arrangements was a loan.

Appeal dismissed.

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...

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