Sovereign Assurance Co Ltd v Commissioner of Inland Revenue
[2012] NZHC 1760
•19 July 2012
IN THE HIGH COURT OF NEW ZEALAND AUCKLAND REGISTRY
CIV-2005-404-6802
CIV-2005-404-6803
CIV-2008-404-2609
CIV-2009-404-6443 [2012] NZHC 1760
UNDER the Tax Administration Act 1994
BETWEEN SOVEREIGN ASSURANCE COMPANY LIMITED
First Plaintiff
ANDASB BANK LIMITED Second Plaintiff
ANDSOVEREIGN SERVICES LIMITED Third Plaintiff
ANDCBA ASSET FINANCE (NZ) LIMITED Fourth Plaintiff
ANDCBA FUNDING (NZ) LIMITED Fifth Plaintiff
ANDCBA DAIRY LEASING LIMITED Sixth Plaintiff
ANDCOMMISSIONER OF INLAND REVENUE
Defendant
Hearing: 23, 24, 26, 27, 30 April 2012
1, 2, 3, 4, 7, 8, 9, 10, 11, 14, 15, 16, 21, 22, 23, 24 May 2012
Counsel: L McKay, R G Simpson, M McKay and B R Miles for plaintiffs
D J Goddard QC, H W Ebersohn and R A Hearn for defendant
Judgment: 19 July 2012
RESERVED JUDGMENT OF DOBSON J
Solicitors:
This judgment was delivered by me on 19 July 2012 at 11.30am pursuant to r 11.5 of the High Court Rules.
Registrar/Deputy Registrar
Bell Gully, DX CP20509, Auckland for plaintiffs
Crown Law, PO Box 2858, Wellington for defendant
SOVEREIGN ASSURANCE COMPANY LIMITED v COMMISSIONER OF INLAND REVENUE HC AK CIV-2005-404-6802 [19 July 2012]
Contents
Nature of the dispute ......................................................................................................................... [1] Sovereign as a start-up insurer ...................................................................................................... [21] The reinsurance treaties ................................................................................................................. [26] The evidence .................................................................................................................................... [43] Witnesses for Sovereign ................................................................................................................ [44] Witnesses for the Commissioner ................................................................................................... [52] The accruals rules – overview ........................................................................................................ [59] Sequence of issues............................................................................................................................ [65] Can the commission arrangements be analysed separately?....................................................... [71] Marac Life Assurance Ltd v Commissioner of Inland Revenue .................................................... [80] The accounting standards............................................................................................................. [109] Do the commission arrangements constitute a contract of insurance? ..................................... [130] Common law definition............................................................................................................... [131] Was there transfer of significant risk? ........................................................................................ [147] Timing risk .................................................................................................................................. [176] Balance of money flows under commission arrangements taxable? ......................................... [181] Base component of money flows capital in character? .............................................................. [202] Conclusion...................................................................................................................................... [214] Costs ............................................................................................................................................... [217]
Nature of the dispute
[1] The issue in this case is the appropriate treatment for tax purposes of components of reinsurance contracts (the Treaties) entered into by the first plaintiff (Sovereign) with three reinsurers of life insurance risks, each domiciled in Germany. Nothing turns on the identity of the reinsurers. They were referred to in the proceedings as Gerling, Hanover Re and Cologne Re. Throughout the proceedings, the terms concluded between Sovereign and Gerling were treated as representative of all of Sovereign’s relevant reinsurance contracts.
[2] The Treaties provided for two sets of money flows between Sovereign and the reinsurers. First, Sovereign paid premiums to reinsure defined proportions of the mortality risk1 it had assumed under defined tranches of life insurance policies it had issued. In return, the reinsurers accepted liability to meet the cost of the defined proportions of claims made under those policies. There is no dispute over the manner in which Sovereign accounted for the money flows in both directions on the
reinsurance of those mortality risks.
1 The risk that the life assured would die during the current period of the policy.
[3] The second component of the Treaties involved reinsurers agreeing to pay Sovereign refundable commissions that were quantified as a multiple of the initial premiums received by Sovereign on the life insurance policies it issued. Sovereign had a financing need because the initial costs of establishing life insurance policies substantially exceed the initial premiums paid by the policyholders. Life insurers generally plan to recover those establishment costs out of premiums to be paid by the policyholders over a number of years. Accordingly, payment of the refundable commissions by the reinsurers eased the strain on cash flow for Sovereign.
[4] Sovereign was obliged to repay the refundable commissions in stipulated portions out of the subsequent years’ premiums, so long as the policies on which the reinsurers had paid the commissions remained in force. To the extent that premiums were not received by Sovereign from the policyholders, the terms of the Treaties were taken to free Sovereign of any obligation to “pass on” the remaining instalments in repayment of the refundable commission. The amount to be repaid included an interest component to compensate the reinsurers for the time value of the amounts of the commissions they had paid to Sovereign.
[5] Although on an individual policy basis Sovereign was relieved of the obligation to repay the refundable commission if the policy lapsed, the overall arrangements between Sovereign and each reinsurer were moderated by the operation of a memorandum account (variously referred to as a Deficit Account or a Bonus Account, and which I will refer to as the Bonus Account). The Bonus Account kept track of the total money flows in both directions, and its ultimate purpose was to enable calculation of any profit share to which Sovereign would become entitled if the Bonus Account was in credit, after payment of all amounts outstanding to the reinsurer. On reinsurance of the mortality risk, reinsurance premiums paid by Sovereign were credited to the Bonus Account, and claims paid by the reinsurer were debited to the Bonus Account. On the refundable commissions, amounts paid to Sovereign were debited to the Bonus Account and repayments of the commissions to the reinsurer were credited to the Bonus Account. The interest charge on outstanding amounts of commissions was also debited to the Bonus Account.
[6] This meant that so long as the totality of business between Sovereign and a reinsurer got to the point where payments by Sovereign from all sources were sufficient to make up any deficit from lapsed2 policies, and also for any negative balance between reinsurance premiums paid to the reinsurers and claims met by the reinsurers, then the reinsurer would be paid back all of the refundable commissions plus interest.
[7] Apparently since inception of the Treaties, and certainly for many years, Sovereign had accounted for this second set of money flows, comprising the refundable commissions received, and repayments of them plus interest, on the basis that the refundable commissions were treated as income in the years they were receivable, and repayments of commission plus interest were treated as expenses in the years that they were payable. However, the defendant (the Commissioner) has assessed Sovereign, relevantly for the 2000 to 2006 income tax years, on the basis that the refundable commissions and their repayment amount to a financial arrangement to which the accruals rules in Part E Subpart H of the Income Tax Act
1994 (the Act) apply. The consequence is that the Commissioner treats the refundable commissions as a non-taxable receipt (effectively of working capital), and only the portion of repayments in excess of the amount received by Sovereign (in effect the interest cost on use of the “principal”) are treated as deductible, in a manner spread over the life of the arrangement as required by the accruals rules.
[8] Sovereign’s primary rejoinder is that all money flows under the Treaties are excepted from the application of the accruals rules because they all constitute components of a contract of insurance, and that the two sets of money flows cannot be “unbundled”. Alternatively, if they have to be separately analysed, the components are each contracts of insurance.
[9] Sovereign also challenged the assessments on further alternative grounds. If, contrary to its primary position, the accruals rules do apply to the treatment for income tax purposes of the portion of repayments representing “interest”, then the
remainder of those money flows still have to be dealt with under the core provisions
2 “Lapse” in this sense includes both decisions by policyholders not to continue with the policy, and cases where the life assured dies, generally resulting in a claim under the policy.
in the Act. Sovereign’s position is that applying first principles, the refundable commissions offset the expenses incurred in initiating the insurance policies and have the character of income. Then, as a matter of consistency, the commission repayments are expenses (and accordingly deductible for income tax purposes).
[10] For his part, the Commissioner’s fall-back position is that if the accruals rules do not apply, then the character of the refundable commissions and commission repayments still has to be determined. On the Commissioner’s analysis, the commissions cannot be treated as income “earned” where there is an obligation to repay them, and those money flows accordingly comprise advances and repayments essentially of a capital nature that are not assessable income or deductible expenses. Sovereign attributes to the analysis for the Commissioner on this argument, a necessity to treat the refundable commissions as loans or analogous to loans. Sovereign argues that they lack such a character, so that the Commissioner’s argument is misconceived.
[11] Sovereign is a member of a group of companies under common ownership that are grouped for the purposes of their income tax returns. In the relevant years, the tax calculations for each of the remaining plaintiffs included reliance on losses for tax purposes originally generated by Sovereign. The assessments by the Commissioner have disallowed losses to Sovereign, with the consequence that the parts of those losses applied by the remaining plaintiffs have also been disallowed. Accordingly, the remaining plaintiffs have no independent arguments and the outcome of their respective challenges to the consequential re-assessment of their returns is dependent entirely on the outcome of the challenge by Sovereign.
[12] Sovereign’s claim that the refundable commissions were assessable income is the first half of what would then be consistent treatment for the full extent of repayment of the commissions as being deductible. The Court was spared the details of the finite amounts involved in the assessments, and the parties agreed that the proceedings can be confined to resolution of the status of the money flows in these commission arrangements for income tax purposes. It was also agreed that, if the Commissioner’s approach is correct, it would nonetheless be appropriate for there to be a further amendment to the current assessments to reflect adjustments that have
been identified between the parties in the course of preparing their arguments for trial.
[13] A taxpayer challenging the correctness of an assessment by the Commissioner generally has to establish not only that the assessment by the Commissioner is wrong, but also by how much it is wrong.3 Given the final position of the parties in their closing submissions, I have taken these proceedings as not extending to this latter issue of quantification of any error. Where the accruals rules do apply to a financial arrangement, the Act provides for a range of methods of calculating gross income deemed to be derived, or expenditure deemed to be incurred, by the taxpayer over the life of the relevant transactions, beginning with the
yield to maturity method.
[14] The ultimate alternative provides for a method “that results in the allocation to each income year of an amount that, having regard to the tenor of [alternatives to the yield to maturity method] is fair and reasonable”.4 Sovereign accepts, at least in principle, that this alternative would apply if the Commissioner is correct in assessing under the accruals rules, and I was assured that the parties would co- operate on fine-tuning the numbers in that event. It would therefore follow that if
Sovereign’s challenge to the application of the accruals rules is upheld, then in this case the Commissioner’s assessments could be declared to be wrong without my having to find the extent by which that is so.
[15] A separate part of the tax dispute as it arose originally and which had been included in the proceedings was settled shortly before trial, and need not be addressed. The overall consequence of the parts of the Commissioner’s assessments that are still being disputed result in additional tax liabilities for the plaintiffs of some $47.5 million. Because of the lapse in time since the years in which the additional tax liabilities arise, there is also use of money interest assessed against the
plaintiff companies of some $45 million at the time of the hearing.
3 Tax Administration Act 1994, s 138P, and, for example, Ben Nevis Forestry Ventures v
Commissioner of Inland Revenue [2008] NZSC 115 at [171], [2009] 2 NZLR 289.
4 Income Tax Act 1994, s EH 1(2) and (6).
[16] The practical effect of the differences in approach to tax treatment of the money flows involved is a matter of the timing of recognition of contributions respectively to assessable income and deductible expenses. Because the receipt of amounts as refundable commissions and later repayment of those amounts essentially net off, in some situations such timing differences for income tax purposes might not give rise to meaningful disputes. However, in the present case, re-allocation of tax losses to the years in which they would be available on the basis of the Commissioner’s assessment of Sovereign would not be available to the plaintiffs because of a break in the continuity of ownership of Sovereign that arose
when all of its shares were acquired by ASB Bank Limited in 1998.5
[17] In the case for the Commissioner, the second set of money flows comprising the payments by the reinsurers of refundable commissions and Sovereign’s subsequent repayment of them were described as the “financing component” or “financing arrangement” provided for in the Treaties. That term reflects the Commissioner’s analysis that those money flows comprise the provision of finance for Sovereign and a financial arrangement for the purposes of the accruals rules.
[18] It is common ground that the effect of those money flows was to provide financing for Sovereign. There were numerous references, from the time that the arrangements were put in place, that treated the second set of money flows as “financing”.6 That characterisation was also adopted in an actuarial review conducted by William M Mercer, as at 31 March 1997, which commented in the context of any need for a reinsurance repayment reserve:7
The Company has received financing from reinsurers to fund the acquisition of new business and the company is liable to repay the financing with a predetermined portion of future policy premiums.
[19] However, in arguing Sovereign’s case, Messrs McKay and Simpson were concerned to resist any suggestion that labels attributed to any aspects of the money flows should influence the analysis of their status for income tax purposes. I have
had no difficulty relegating the significance of labels, but that caution may
5 Constraint in s IF 1 of the Act.
6 For example, 7 December 1992 Sovereign letter to Gerling “…financing is repaid over about
5 years” (ABD3/134/540) and the July 1988 memorandum (ABD2/68) described in [32] below.
7 ABD25/639/6155 (document provided post-hearing).
nonetheless be appropriate.8 I have adopted Sovereign’s use of “commission arrangements” as the term used to describe the money flows comprised in the reinsurers’ payment of refundable commissions, and Sovereign’s repayment of them plus interest.
[20] Similarly, the arguments for the Commissioner lend themselves to describing the extent of the refundable commissions paid to Sovereign as the principal component, with the additional component repaid by Sovereign beyond that as “interest”. To neutralise the analysis, I will refer to the amounts advanced as refundable commissions by the reinsurers as the “base component”, when it is necessary to distinguish that from the additional amount intended to be repaid by
Sovereign, which I will refer to as the “additional component”.9
Sovereign as a start-up insurer
[21] Sovereign was incorporated as an insurance company in the late 1980s. The driving force appears to have been the two initial senior executives, Messrs Coon and Hendry who had proprietary interests, and both of whom had experience in overseas life insurance markets, including connections with European reinsurers. I infer that the experience of Messrs Coon and Hendry provided them with contacts with the German reinsurers that led to negotiation of reinsurance treaties, the relevant ones of which took effect from 1 April 1992.
[22] Initially, Sovereign reinsured 95 per cent of the value of life insurance it had underwritten, up to a maximum of $200,000 per policy. By the 2002 income year, the five per cent retention had been increased to 25 per cent through proportionate
reductions in the reinsurers’ level of participation.
8 There was similar sensitivity about the label of “refundable” commissions when that adjective did not appear in the terms of the relevant treaty itself, but only in annexures where the formulae for calculating the rate at which they were to be paid was specified. Nothing will turn on using the adjective, which is convenient for identification purposes, even although there were limits on Sovereign’s obligations to “refund” commissions received.
9 An example frequently cited for Sovereign was of refundable commission received of $100, and repayment of $150. In this example, $100 is the base component, and $50 is the additional component.
[23] Without significant start-up capital, a new life insurer such as Sovereign incurs cash flow strain because the costs of initiating life insurance policies are substantially greater than the first year’s premiums able to be charged. An insurer in Sovereign’s position has to pay commissions to agents or brokers who sell the policies to policyholders, in addition to other expenses such as the cost of medical examinations of the lives assured, and an allocation for its own office and promotional overheads. These initiation costs were put at between two and three
times the first year’s premium.10
[24] In addition, life insurers are required to hold certain minimum levels of capital to provide financial capacity to meet future claims payable to policyholders on adverse assumptions as to the occurrence of claims. Those obligations were not reflected in statute until capital requirements were promulgated by the Reserve Bank in 2011,11 which issued pursuant to the Insurance (Prudential Supervision) Act 2010. However, before that time industry standards still required independent actuarial confirmation of capital adequacy. Those requirements place limits on the extent to which working capital can be funded by borrowings that need to be recognised as
debt in a life insurance company’s financial statements.
[25] In Sovereign’s case, all its shares were acquired by the ASB Banking Group in 1998 so that its capital requirements changed once it had the support of an established bank. The Gerling reinsurance treaty was closed to new business in
2001, so that thereafter the dealings with that reinsurer were confined to the “run off” of business undertaken before then.
The reinsurance treaties
[26] Life insurers routinely reinsure various portions of the liabilities they assume when contracting to make payments on the death of a life assured. The classic form of reinsurance (referred to in the proceeding as “original terms reinsurance”)
involves a reinsurer contracting to meet a set proportion of claims arising under a
10 A worked example provided in Mr Perera’s evidence suggested initiation costs plus the cost of maintaining the policy in its first year at 240 per cent of the first year’s premium: Perera first brief at [60].
11 Reserve Bank of New Zealand 2011 Solvency Standard for Life Insurance Business.
portfolio of life insurance policies, in return for reinsurance premiums paid by the insurer to the reinsurer. Because the reinsurer has not incurred any of the establishment costs, the reinsurer also pays the insurer a commission, intended to reimburse part of the costs of initiating the policy. Thereafter, the insurer accounts to the reinsurer for a defined proportion of all future premiums on the policy, for as long as it continues. The level of that on-going payment also reflects recovery over time of the commission paid by the reinsurer to the insurer, when the policy is initiated.
[27] The effect of such reinsurance is to transfer the mortality risk from the insurer to the reinsurer, to the extent of the portion of the portfolio of policies to which the reinsurance relates. In this way, the insurer and reinsurer share the risks, including the length of the period during which premiums will continue to be received. In insurance industry parlance, the concept is described as “ceding” portions of the risks underwritten by the insurer. Hence reference to a direct insurer in Sovereign’s position as the “ceding insurer” or the “cedant”.
[28] Because recovery of the initial costs incurred by an insurer in establishing a life policy is spread over a number of years, the insurer is exposed to the discrete risk that the policy will lapse before the establishment costs have been fully recovered. That risk is recognised in the insurance industry as “lapse”, or “persistency” risk. In original terms reinsurance, the lapse risk is shared in the same way as mortality risk is re-allocated.
[29] Sovereign’s case is that by negotiating to include the second set of money flows within the reinsurance treaties, it addressed this lapse risk. The inclusion in the reinsurance treaties of this arrangement meant that the reinsurers effectively funded a substantial portion of the establishment costs of the relevant policies and, within the terms of the Treaties, the reinsurers were dependent on continuation of
those policies for instalments repaying that outlay.12 Sovereign and the reinsurers
12 Payment of the refundable commission on some types of policies was split, 85 per cent at outset and 15 per cent in the 13th month of the policy. For others, payment was of 100 per cent at the outset.
treated the arrangement as transferring lapse risk from Sovereign to the reinsurers, to the extent of the refundable commissions, and their subsequent repayment.13
[30] The evolution of various forms of “financial reinsurance” (Fin Re) was addressed in a paper prepared for the United Kingdom Actuarial Society in October
1993 by Messrs Paul Brett and Alex Cowley.14 The authors interpreted Fin Re as
any form of reinsurance that does not simply cover the pure risk that the original insurer is ceding to a reinsurer, but also contains a financial element. There are numerous references in the paper to the reinsurer, via the Fin Re device, providing financing for the original insurer. In the context of an educational purpose within the actuarial profession, the paper described positive features which the authors attributed to each of original terms reinsurance, deficit account reinsurance, and surplus relief. Deficit account reinsurance is an alternative description of what is referred to in this judgment as Bonus Account reinsurance. Surplus relief describes the concept where a reinsurer make an advance (likely to be a further advance) to the direct insurer in respect of a block of policies that are already in force, in contrast to the Bonus Account or original terms reinsurance that involve money flows reflecting the writing of new business by the direct insurer.
[31] The Brett and Cowley paper characterised money flows such as the refundable commissions in this case, as the provision of financing for the insurer. Their paper also treats that component as providing capital for the insurer.15
Although conscious of attributing consequences to labels when that is not justified, a consideration of the whole of the Brett and Cowley paper leads inevitably to the conclusion that those respected actuaries treated the refundable commissions component of a reinsurance arrangement such as occurred in this case, as the provision of finance by the reinsurer to Sovereign, and that the purpose of doing so
was the provision of a form of working capital.
13 Phyel brief at [28].
14 ABD4/154.
15 See, for example, at 14 “…the capital provided is directly related to the amount of new business strain and is given when the new business strain arises”. And at 36, the conclusion that “Fin Re is a cost effective form of ‘capital’ with a risk management element.”
[32] The Treaty documentation is unusually brief for potentially long-term, relatively complex international contractual commitments that involved tens of millions of dollars. The documentation between Sovereign and Gerling began with a “Memorandum on Discussions” held in July 1988 between their representatives. The single page memorandum recorded preliminary agreement on the extent of reinsurers’ expenses that might be allowed for, the rate of interest at which “the outstanding financing balance” would be carried forward, and the basis on which Sovereign would get a 75 per cent profit share after amortisation of the Bonus
Accounts.16
[33] The treaty itself comprised just 13 pages of double-spaced provisions, with a further eight pages of annexures recording details of types of policy, formulae for calculation of the various payments and schedules of rates. The treaty was completed in October 1993 but recorded that it was to take effect from 1 April 1992. The treaty provided that Sovereign would cede a 38 per cent share of the sum at risk on all policies issued by Sovereign, up to a maximum of $200,000 on any one life at
inception.17
[34] By article 4 of the treaty, Sovereign was committed to paying the reinsurer risk premiums and commission repayments on the basis specified in an annexure to the treaty. The commitment to pay the required risk premium payments was stated to continue as long as the ceded policies were in force. The commission repayments were to continue so long as no payments were due from the reinsurer to Sovereign under the Bonus Account agreement. There was no express recognition recorded in the Gerling treaty that Sovereign’s obligation to repay instalments on the refundable commissions would cease in respect of a particular policy, when that policy lapsed. Apparently such a provision was explicit in another of the Treaties. The parties agreed to determine the issues on the basis that such a provision did apply.
[35] By article 5 of the treaty, the reinsurer was committed to pay reinsurance commissions to Sovereign in accordance with formulae set out in an annex to the
treaty. The relevant annexure specifying the formulae for calculating the amounts
16 ABD2/68.
17 ABD1/17. Percentages agreed with the other reinsurers meant that Sovereign initially ceded a total of 95 per cent of the risks insured.
payable by the reinsurer described them as “refundable commissions”, and related to percentages of the premiums Sovereign charged the policyholder. Article 5 also committed the reinsurer to returning a bonus to Sovereign, on the basis stated in the Bonus Account agreement.
[36] Article 6 of the treaty specified that the reinsurers’ liability was to commence and cease simultaneously with that of Sovereign, and that the reinsurer would, in every respect, follow the underwriting fortune of Sovereign in proportion to its share.
[37] Article 8 of the treaty required Sovereign to account to the reinsurer for a proportionate part of commissions actually recovered from its agents or brokers, in cases where policies had lapsed. This provision reflected the arrangements that Sovereign had with the agents or brokers selling its life insurance policies, for Sovereign to be reimbursed for portions of the commission paid to the agents/brokers for signing up the policyholder, in the event of an early lapse of the policy. The agents’ obligations to repay commissions are graduated, so that smaller portions become repayable as the policy remains in force for longer. The evidence suggested that life insurance companies have variable levels of success in enforcing such repayment obligations, when policies have lapsed.
[38] The Treaties also contained a further provision that might be characterised as the last resort for the reinsurers to recover the refundable commissions.18 If any winding up or bankruptcy proceedings were pursued against Sovereign, or it lost its licence to transact life insurance, or came under the managerial supervision of the government or any other authority, all outstanding amounts in the Bonus Account would become immediately repayable, with the reinsurer having priority
immediately after the claims of policyholders. Depending on circumstances, that crystallising of the reinsurer’s right to be paid all outstanding amounts may have a bearing on the character of the risk assumed by the reinsurers in advancing the
refundable commissions.
18 See, for example, articles 20(4) and 21(3) of the Gerling treaty.
[39] A Bonus Account agreement had been completed as a separate document in March 1989, to relate to a predecessor of the treaty completed in 1993. The totality of its operative terms was as follows:19
One bonus account shall be maintained with respect to all Reassurance Agreements between the CEDING OFFICE and the REINSURER, which refer to a bonus payable by the REINSURER, where the bonus is calculated as follows:
The REINSURER pays to the CEDING OFFICE 75 per cent of profits emerging after the amortization of total loss carried forward, bearing interest based on the current 2-year New Zealand government bond rates plus
4 per cent and after reinsurance expenses of 2 per cent (not less than
30,000 NZ $ and not more than 300,000 NZ $).
[40] There was a similar structure of annexures providing details, and then a series of addenda to the Bonus Account agreement to reflect alterations in the arrangements between the parties. For instance, in February 1993, the parties agreed to operate a second Bonus Account that was to be maintained in Deutschmark. The apparent purpose of that second account, which was to reflect in Deutschmark all entries in the original Bonus Account maintained in New Zealand dollars, was to share between the parties any currency rate losses incurred by the reinsurer. Subsequently, the parties elected not to enforce that arrangement.
[41] Then in February 1994, but purporting to have backdated effect to 1 April
1992, the parties agreed to split the Bonus Account into two components, respectively for all business written up to 31 March 1992, and for all business written after 1 April 1992. Again, it appears that the division between the two categories of business was also not maintained in the practical operation of the Bonus Account.
[42] Although the majority of the refundable commissions were paid by reference to the volume of new business underwritten by Sovereign, on a small number of occasions it also negotiated with Gerling for payment of additional lump sums. The evidence instanced a $3.7 million advance in or about early 1994. This was described as “surplus relief” and was treated as providing further compensation to
Sovereign in respect of the establishment costs of existing business. Sovereign’s
19 ABD1/3.
initial commitment was to repay such surplus relief by a proportionate increase in the portion of on-going premiums received by Sovereign, that it would on-pay to the reinsurer. As with the refundable commissions themselves, the extent of those repayment obligations constituted a debit to the Bonus Account. An actuarial review of Sovereign as at 31 March 1997 completed by William M Mercer in May 1998 recorded what that review described as “additional reinsurance financing” at
$13.0 million.20 The case was argued on the basis that such surplus relief
arrangements were not directly relevant to the years being assessed in that all such payments to Sovereign had been repaid by 2000.
The evidence
[43] Only two witnesses of fact were called in the case, and even with those two, their evidence extended to matters of opinion.
Witnesses for Sovereign
[44] The first was Mr Ian Perera, who is the chief financial officer of Sovereign’s parent company, having previously been employed by Sovereign as an actuary since March 1999. Mr Perera provided background to Sovereign’s life insurance business, and the intended purpose and effect of the Treaties. He also provided his actuarial analysis of the impact of the Treaties, and in particular his opinion on the transfer of lapse risk to the reinsurers effected by the commission arrangements.
[45] The second witness of fact was Dr Pyhel, a long-standing officer with Gerling, and more recently employed in a senior management role within a group of companies linked by ownership with Gerling. Dr Pyhel described the process by which reinsurers such as Gerling negotiate reinsurance treaties, how the reinsurers perceive the allocation of risk involved in various forms of reinsurance of life insurance business, and how Gerling accounts for the money flows involved in the
treaty with Sovereign.
20 ABD25/639/6159 (document provided post-hearing).
[46] Sovereign also called expert evidence from three actuaries and three accountants. The first actuary was Mr Bharat Bhayani, who qualified and worked as an actuary in England in the late 1980s and into the 1990s. He was seconded to work as an actuary at Gerling for 18 months beginning in March 1993, and had a range of experience as an actuary before becoming a partner of accounting services firm, Deloitte, based in Cologne, from where he is responsible for co-ordinating Deloitte’s actuarial practices in continental Europe.
[47] The second actuary was Mr Stuart Davies who had previously worked as an actuary for insurance companies before joining the accounting services firm, Ernst & Young. He is a partner in that firm and leads its life reinsurance activity in Europe.
[48] The third actuary was Mr Grant Peters who is currently a partner of Ernst & Young in Australia. Mr Peters was called in reply principally to respond to criticisms of a model used by Mr Perera that was intended to demonstrate the nature and extent to which lapse risk had been transferred to the reinsurers under the commission arrangements.
[49] The first of the accountants called by Sovereign was Mr Stuart Wilson who is a partner of Ernst & Young in London. His expertise includes application of the United Kingdom accounting standards to money flows of the types provided for under the Treaties.
[50] The second accountant was Mr William Wilkinson who has recently retired as a partner of the accounting firm, KPMG in Auckland. He has had experience in New Zealand and elsewhere in accounting for insurance entities and provided largely consistent evidence with that of Mr Wilson in relation to the accounting treatment he contended for, in relation to the money flows under the Treaties.
[51] The third accountant was Mr Keith Nicholson who is a recently retired partner of KPMG in London, and is currently a director of life insurance companies in the United Kingdom. His evidence, which was called in reply, addressed his opinion that the components of the Treaties ought not to be “unbundled” for
accounting purposes, and other technical issues on the appropriate accounting treatment for such money flows.
Witnesses for the Commissioner
[52] The Commissioner called five expert witnesses - three actuaries and two accountants. Each of the actuaries was based in the United Kingdom and they all had experience in actuarial work in relevant areas in the United Kingdom and Europe.
[53] The first actuary called was Mr Paul Bispham. Mr Bispham had previously worked for another of the reinsurers with whom Sovereign contracted, Cologne Re, and had been involved in the development, design and pricing of a range of structures that he generically described as “financing reinsurance”. Mr Bispham questioned whether management of lapse risk was a commercial objective of arrangements of this kind which he saw as predominantly for the purposes of providing finance. He was critical of the model Mr Perera had produced to demonstrate the transfer of lapse risk.
[54] The second actuary was Mr Harvey Duckers, who is currently the chief insurance actuary at the United Kingdom’s Government Actuary’s Department. Mr Duckers had some prior experience within the reinsurance business. Mr Duckers had critically analysed Mr Perera’s model and suggested a different analysis of the transfer of lapse risk in his own models.
[55] The third actuary called was Mr Roger Laker, who had worked as an actuary for various life insurance companies for relatively substantial periods, and has more recently been a consulting actuary. He opined as to the substantive character of the risks involved in the reinsurance arrangements.
[56] The first accountant called for the Commissioner was Professor Michael Adams from the University of Bath in the United Kingdom whose specialty was in the accounting, finance and economic aspects of insurance and risk.
[57] The second accountant called was Mr John Hagen, a senior New Zealand accountant and former chair of the Accounting Standards Review Board.
[58] There was no material dispute as to what had occurred and the differences in the evidence focused instead on how transactions ought to be characterised in the accounting sense, and how the contractual arrangements ought to be characterised for actuarial purposes relative to the allocation and transfer of insurance risk. It is unnecessary to review the content of the evidence from each of the witnesses at this stage, and I will acknowledge the relevant components of their evidence on a topic by topic basis as I consider the issues.
The accruals rules – overview
[59] The provisions of the Act invoked by the Commissioner are in Part E (Timing of income and deductions), Subpart H (Financial arrangements). Subpart H is arranged in two divisions, and it is Division 1 that would apply here, because the money flows provided for in the Treaties, if subject to the rules, constitute financial arrangements entered into on or before 20 May 1999.
[60] Both parties cited numerous extracts from a text on the accrual regime.21
That text comments on the purpose of the accruals rules, and their objective, in the following terms:22
Their purpose is to ensure that all returns on financial arrangements are brought to tax on a progressive basis over the term of the financial arrangement concerned. The term “financial arrangement” is very broadly defined and includes virtually any arrangement where there is a deferral of the passing of consideration.
And:23
The objective that emerged gradually over the original consultative process was the dilution of the capital/revenue distinction, so that all financial arrangements would receive neutral tax treatment regardless of their form.
21 Susan Glazebrook and others New Zealand Accrual Regime – a Practical Guide (2nd edition, CCH, Auckland 1999).
22 At [100].
23 At [102], p 7.
...
The theory behind the change is that, although financial arrangements differ in form (for example, futures contracts as against debt instruments), in many cases they have the same economic effect. Thus although in economic terms gains from those financial arrangements are the same, under the old income tax law some gains from some financial arrangements were classed as capital and non-taxable while others were classed as income and taxable.
[61] In terms of the scope of application of the accruals rules, the authors of the text also observed:24
The definition of financial arrangement is so wide that it could include numerous everyday transactions which lack any element or indicia of lending. When interpreting the accrual regime provisions, the prudent approach is to assume that all transactions which result in a timing delay in the exchange of benefits are ‘financial arrangements’ in this wide sense. The inquiry should then be whether exceptions and exemptions apply and, if not, whether there are, as a result of an arrangement being a ‘financial arrangement’, any accrual rule consequences. A good rule of thumb is to assume everything is a financial arrangement or has some relationship to a financial arrangement until the contrary is definitively proved.
[62] Section EH 14 contains definitions that apply to Division 1 of Subpart EH. These include:
“financial arrangement” means
(a) any debt or debt instrument, and
(b) any arrangement (whether or not such arrangement includes an arrangement that is a debt or debt instrument, or an excepted financial arrangement) whereby a person obtains money in consideration for a promise by any person to provide money to any person at some future time or times, or upon the occurrence or non-occurrence of some future event or events (including the giving of, or failure to give, notice), and
(c) any arrangement which is of a substantially similar nature (including, without restricting the generality of the preceding provisions of this subparagraph, sell-back and buy-back arrangements, debt defeasances, and assignments of income),
but does not include any excepted financial arrangement that is not part of a financial arrangement:
[63] The definition of “excepted financial arrangement” lists a variety of forms of
arrangement in 22 separate paragraphs that are excepted from the scope of financial
24 At [205].
arrangements to which the accruals rules will apply. Paragraph (b) of that definition is:
a contract of insurance or membership of a superannuation scheme;
[64] The scope of the qualification at the end of the definition of “financial arrangement”, specifying that “financial arrangements” do not include “any excepted financial arrangement that is not part of a financial arrangement” is to be read with s EH 2 which is in the following terms:
EH 2 Excepted financial arrangement that is part of financial arrangement
The amount of the gross income deemed to be derived or the expenditure deemed to be incurred by a person in respect of a financial arrangement under the qualified accruals rules shall not include the amount of any income, gain or loss, or expenditure, that is solely attributable to an excepted financial arrangement that is part of the financial arrangement.
Sequence of issues
[65] By the end of the hearing, it was accepted for Sovereign that the Gerling treaty included a financial arrangement within the very broad definition of paragraph (b) of that expression. The Commissioner’s reliance on that broad definition obviates the need to review arguments that had previously been exchanged on whether the commission arrangements would constitute a debt or debt instrument within the narrower definition in paragraph (a) of that expression.
[66] Accordingly, the first issue is whether the two sets of money flows provided for under the treaty, namely the reinsurance of mortality risk, and the commission arrangements, can be separated for analysis as to the application of the accruals rules.
[67] Depending on whether the commission arrangements can be separated, the next issue is whether, either the whole of the treaty if its components cannot be separated, or alternatively the commission arrangements if they can be separated, constitute a contract of insurance so as to come within the exclusion for excepted financial arrangements.
[68] If the analysis underlying the Commissioner’s assessments is correct in respect of the ability to consider the commission arrangements separately, and that on such separate consideration they do not constitute a contract of insurance, then the outcome would be the application of the accruals rules to the additional component of the commission arrangement money flows. In that event, the next issue would be whether Sovereign is correct in contending that the core provisions of the Act would still apply to the base component of the money flows in the commission arrangements, in which event Sovereign would argue that the refundable commissions received by Sovereign are still to be treated as assessable income, and the repayment of those amounts are to be treated as deductible expenses for the purposes of assessing Sovereign’s taxable income, in the years in which the repayments were payable. The Commissioner disputes this characterisation, arguing that if the accruals rules do apply, then the treatment for income tax purposes of the additional component is all that should be reflected in assessing Sovereign’s income tax obligations.
[69] The arguments for the Commissioner in resisting any residual issues for income tax purposes if the accruals rules do apply is complementary to the ground covered in the Commissioner’s alternative argument. That is, if the Commissioner was wrong to invoke the accruals rules, then the base component in the money flows for the commission arrangements is nonetheless to be ignored for income tax purposes because it is capital in nature, and only the additional component of the payments Sovereign made to the reinsurer would fall to be treated as deductible expenses in the years they became payable.
[70] In the course of argument, both parties sought to attack the present position of the other, by identifying reversals of stances previously relied on by the opposing party that are consistent with the analysis now advanced for the criticising party. None of these changes of position give rise to any suggestion of estoppel, and the parties are not constrained in any way by the terms of previous arguments, from advancing at the hearing the analysis they consider best reflects their position in what is a relatively arcane area. During closings, counsel were inclined to agree with
my reaction that no significance should be attributed to positions previously adopted on behalf of the parties that are inconsistent with the arguments now advanced.25
Can the commission arrangements be analysed separately?
[71] The Commissioner’s assessments proceed on the basis that the Treaties are able to be separated into two components for the purposes of applying the accruals rules. First, the reinsurance of the mortality risk, and secondly, the commission arrangements. On the basis that these two components should be analysed separately, the Commissioner has treated the commission arrangements as a “financial arrangement” within the broad definition of that expression in s EH 14(b). He submitted that the arrangement does not constitute an insurance contract so it does not qualify as an “excepted financial arrangement” as defined in s EH 2.
[72] Sovereign argued that this approach is wrong. It contended that the two components of the Treaties are indivisible, were treated by the parties to them as such and cannot be deconstructed in the way that the Commissioner contended. Sovereign argued that its position is supported by the relevant accounting standards, which require companies to account for all money flows in an unbundled form.
[73] Further, Sovereign argued that the commission arrangements do involve a material transfer of insurance risk and therefore qualify as a contract of insurance, irrespective of whether the two components of the Treaties are treated as indivisible or are analysed separately.
[74] To ascertain the scope of what might constitute a “financial arrangement”, it
is appropriate to begin with the terms used in s EH 14 of the Act. “Arrangement” is defined in the Act as meaning:26
25 Compare Medical Defence Union v Department of Trade [1979] 2 WLR 686 at 698E per Megarry VC: “...a contention on a point of law may be equally sound or unsound whether it is the product of first thoughts, or second thoughts, or no thoughts at all”.
26 Section OB 1 of the Act, the application of that general definition to the more specific definition of “financial arrangement” being confirmed in Commissioner of Inland Revenue v Dewavrin Segard (NZ) Ltd (1994) 16 NZTC 11,048 at 11,051.
…any contract, agreement, plan or understanding (whether enforceable or unenforceable), including all steps and transactions by which it is carried into effect.
[75] Sovereign argued that the emphasis in this definition is on aggregating steps and transactions, rather than separating them. However, the approach to recognition of “an arrangement” will depend on context.
[76] Here, it is clearly intended that a financial arrangement may be a part or component of a larger arrangement. The words in s EH 14 “… (whether or not such arrangement includes an arrangement that is a debt or debt instrument, or an excepted financial arrangement)”, where they appear near the beginning of para (b) of the definition of “financial arrangement”, refer to an (implicitly larger) arrangement that may contain a debt or debt instrument, or an excepted financial arrangement. Consistently, at the end of that definition there is an exclusion for excepted financial arrangements where they are not part of a financial arrangement.
[77] When the initial reference in parentheses and that exclusion are read together with s EH 2 (which confines the exclusion of gross income deemed to be derived or expenditure deemed to be incurred to those items that are “solely attributable” to an excepted financial arrangement that is part of the financial arrangement), they point to a process for deconstructing component parts of wider arrangements, so as to apply the accruals rules either to the financial arrangements within a larger arrangement, or to the components of a financial arrangement that qualify. It is only where the money flows are solely attributable to an excepted financial arrangement that they are excluded.
[78] Mr Goddard emphasised the connotations of “a part” as necessarily being a component of some larger entity. The accruals rules do not need the arrangement to have status as a stand-alone transaction for other purposes. These rules require, in appropriate circumstances, analysis of a component (part). There is a very wide range of circumstances in which a deferral of consideration will feature as an aspect of all manner of commercial arrangements. Accordingly, the rationale for isolating the consequences of deferral of the consideration that is to pass from the other
features of a transaction would be frustrated if such separate analysis for income tax purposes was not available to the Commissioner.
[79] The references in s EH 2 to “income deemed to be derived” and “expenditure deemed to be incurred” are also suggestive of a process of recasting actual money flows. It may reflect no more than the process of accrual accounting in which the incurring of obligations to pay, and entitlements to be paid, trigger the requirement to account for the activities, rather than awaiting the inwards and outwards cash movements. However, the use in s EH 2 of the concept of “deemed” income and expenditure is consistent with the analysis of financial obligations, when dealing with the timing of transactions for income tax purposes, by deconstructing and reconstructing the manner in which such transactions may have been recorded in a different form for other purposes.
Marac Life Assurance Ltd v Commissioner of Inland Revenue
[80] An important element of Sovereign’s arguments against separate consideration of the reinsurance of the mortality risk and the commission arrangements was its reliance on the Court of Appeal decision in Marac Life Assurance Ltd v Commissioner of Inland Revenue.27 In a different context, that decision required the components of a contract, one of which constituted an insurance contract, to be treated as indivisible. The outcome was that the other,
investment, component of the contract was treated as sharing the character of an insurance contract.
[81] In Marac, the status of certain “life bonds” issued by the company was considered for the purposes of the Income Tax Act 1976, as well as the Life Insurance Act 1908 and the Securities Act 1978. The life bonds had been designed as investment products so that the return to the investor was characterised as “bonuses” in return for a payment characterised as a “premium”. This meant that the return on the money paid to Marac was characterised as being tax free because the income tax legislation at the time treated bonuses payable on a policy of life
insurance as not being assessable for income tax purposes.
27 Marac Life Assurance Ltd v Commissioner of Inland Revenue [1986] 1 NZLR 694 (CA).
[82] The life insurance element comprised of Marac’s commitment to pay the full interest return for the term of the bond (up to 10 years for the longest on offer) on the event of an earlier death of the life assured. On Marac’s own accounting for this component of the transaction, it allocated 0.5 per cent of the “premium” to cover the risk that the full extent of bonuses would be payable on an investor’s death prior to maturity.
[83] Sovereign relied on the Court of Appeal’s analysis that treated the life bonds as an indivisible set of arrangements. The Court did not consider separating out the investment and life insurance components. The Commissioner’s rejoinder in relation to this was that there had been no argument in Marac that the contracts for the life bonds ought to be bifurcated in any way, and that the whole argument had proceeded on the basis that, assessed overall, it was either a contract of life insurance, or not.
[84] In Richardson J’s analysis:28
Each sum payable by Marac is a single unsubdivided sum as is the premium payable by the investor and there is no warrant for attributing to the parties alternative contractual arrangements for the investment of the premiums paid.
[85] Given that in Marac there was a single undifferentiated “premium” paid, it is understandable that the challenge to its status was on an “all or nothing” basis. It was argued for Sovereign that it would be highly unlikely to have been determinative if the premium in Marac had been separated into two components. It was speculated that respect for form would still have dictated the same outcome, namely accepting the contract as one of insurance. That point is not borne out by the analysis, which relied on the undifferentiated form in which the contract was undertaken. It seems inevitable that the Court’s analysis would have been different, and require a quite different rationale, if differentiated payments would still have led to the same outcome.
[86] Mr McKay also emphasised the finding in Marac that the contract amounted to one of life insurance notwithstanding the statistically insignificant portion of the
amount invested in each bond that was allocated to cover the extent of life insurance
28 At 706.
risk assumed. That approach reflected the Court’s respect for the form in which the
transaction had been undertaken. He cited the observation from Richardson J:29
Investors are free to enter into whatever lawful financial arrangements will suit their purposes. They cannot be treated as having entered into a different arrangement which would or might have achieved somewhat similar economic advantages and whether or not they ever had that alternative in contemplation. If Marac life bonds are policies of life insurance that is the end of the inquiry.
[87] That observation was immediately followed in Richardson J’s judgment by
the following:30
The true nature of a transaction can only be ascertained by careful consideration of the legal arrangements actually entered into and carried out: not on an assessment of the broad substance of the transaction measured by the results intended and achieved or of the overall economic consequences.
[88] That approach of apparent strict adherence to legal form was qualified later in the same paragraph with the observation that there may be a statutory provision that mandates a broader or different approach.
[89] Mr McKay submitted that Marac remains good law, in part in reliance on the more recent Court of Appeal decision in Commissioner of Inland Revenue v Gulf Harbour Development.31 That case involved the issue of redeemable preference shares which carried with them the rights to membership of a golf club operated by the taxpayer. The taxpayer treated the supply of preference shares as exempt for the purposes of the Goods and Services Tax Act 1985 (GST), being a form of financial
service. However, the Commissioner contended that the shares included the supply of membership rights to the golf club which were a taxable supply for the purposes of the GST assessment. He argued this on the basis that the substance of the transaction was the supply of the membership rights, or alternatively that there were two separate supplies, the first of the preference shares being an equity security and therefore GST exempt, and the second the supply of membership rights which were
subject to GST.
29 At 705-706.
30 At 706/51-54.
31 Commissioner of Inland Revenue v Gulf Harbour Development (2004) 21 NZTC 18,915.
[90] The Court of Appeal adopted the approach reflected by that Court in Marac. It rejected the prospect of analysing the substance of the transaction for the purposes of liability for GST and also rejected the prospect of separating it into component parts.
[91] In contrast to Marac, the present case does involve two separately identifiable series of money flows that reflect different and discrete (if overlapping) commercial dynamics. Sovereign could conceivably have contracted just for the mortality reinsurance, or could have obtained the two components from different reinsurers.32 The outcome on each component reflected different circumstances, with prospects for each of mortality risks and lapse experience to perform differently from the other over time. Their interdependence arose in calculating an overall outcome of the dealings between Sovereign and the reinsurer, but that by no means made their performance inseparable.
claimed as deductible, Hill J observed for the Court:81
80 FCT v Firth 2002 ATC 4346 (FFC).
81 At [73]-[74].
More fundamentally, it is not in our view correct to say that a provision limiting a lender to recourse to particular funds or assets for repayment of an advance is inconsistent with the transaction being characterised as a loan.
…
It is well established that it is possible to have a contract of loan in which the parties agree that the lender is limited to recourse to particular funds or assets for repayment of the loan:
…
Where the lender’s recourse is limited to particular funds or assets, the possibility that the funds or assets will be insufficient to recoup the advance in full is a risk incurred by the lender. That risk will ordinarily be reflected in the rate of interest charged on the moneys borrowed. Nonetheless, the limited recourse feature of the transaction does not alter its character as a loan.
[211] By analogy, the limitations on the financier’s recourse cannot be determinative in depriving the commission arrangements of loan-like character, when analysing the base component as provision of working capital by the financier to the recipient of the finance.
[212] Here, the risk that adverse events will prevent complete repayment to the reinsurer is at least partially addressed by the finite obligation Sovereign would have to repay all outstanding amounts when any of a range of signals of financial or regulatory stress arise. Although in many contingencies, that fall-back position may not adequately protect the reinsurer’s financial interests, it is relevant to the analysis of the legal position between the provider and the recipient of the financing. Its effect is that in a range of circumstances where the Bonus Account may not, or is likely not to, amortise, that risk triggers an obligation for Sovereign to repay all the amounts outstanding.
[213] In all these circumstances, I am satisfied that the base component in the money flows within the commission arrangements is capital in nature. The consequence is that, if I were wrong to treat the accruals rules as applying to the commission arrangements as a financial arrangement, then, on application of core taxing provisions, the base component in the refundable commissions received and repayments made by Sovereign would be excluded for the purposes of calculating taxable income. That conclusion coincides with my finding in rejecting Sovereign’s
alternative proposition, namely that even if the accruals rules apply to the additional component of the commission arrangement money flows, then the base component is to be dealt with as constituting taxable income and assessable deductions. I have found that not to be the case.
Conclusion
[214] In summary, I have found that the commission arrangements are to be considered separately from the other components of the money flows under the treaty, and that those commission arrangements constitute a financial arrangement for the purposes of the accruals rules. They are not a contract of insurance so as to qualify as an excepted financial arrangement.
[215] Once the accruals rules are applied to the additional component representing the consideration for deferral of Sovereign’s repayment of the amounts received as commissions, the base component of those money flows becomes irrelevant for income tax purposes. Sovereign is therefore wrong in its alternative contention that the commissions received and subsequent repayments should be added respectively to its assessable income and deductible expenses.
[216] Against the contingency that I am wrong in upholding the Commissioner’s application of the accruals rules, then on the alternative contention for the Commissioner, the base components in the money flows comprising refundable commissions received, and repayment of the commissions by Sovereign, are capital in nature and the interest component would be the only part of the money flows that is relevant for income tax purposes.
Costs
[217] The Commissioner has succeeded in defending the assessments and is entitled to costs. If the parties cannot agree the issues as to costs, I will, in the first instance at least, receive memoranda.
[218] I am grateful to all counsel for the manner in which they focused constructively on the issues requiring determination and dealt efficiently with the relatively dense subject matter of the proceedings.
Dobson J
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