|Greg Neill||Brendan Brown|
The case concerns the tax treatment of treaty reinsurance contracts between Sovereign Assurance (a New Zealand resident life insurer) and three reinsurers. Simplifying matters considerably, there were two components to each of the treaties:
- Under the first, Sovereign paid premiums in return for the reinsurers agreeing to reinsure defined proportions of mortality risk that Sovereign had assumed under defined tranches of policies it had issued. (There was no dispute over Sovereign's tax treatment of this aspect.)
- Under the second, the reinsurers paid Sovereign commissions, quantified by reference to initial premiums received by Sovereign in respect of life insurance policies it issued. Sovereign was obliged to make payments, which were termed "commission repayments", calculated as a percentage of premiums received from policies to which the arrangement related.
In addition, there was a bonus account. Payments made to Sovereign under a treaty were debited to the bonus account, and payments made by Sovereign were credited to it. The purpose of the bonus account was to enable the calculation of any profit share to which Sovereign would become entitled once the bonus account reached a credit balance (after full payment of the commission repayments to the reinsurers). Sovereign would be entitled to a percentage of any credit balance.
Issues in dispute
Sovereign had treated the commissions as income in the years receivable and the commission repayments as deductible expenditure in the years they were payable to the reinsurer. But Inland Revenue contended that the commission received by Sovereign and the commission repayments made by it under each treaty should be treated like a loan under New Zealand's financial arrangements rules. This meant that Sovereign would recognise net expenditure over the life of each treaty rather than recognising gross receipts and payments as income earned and expenditure incurred. This timing difference mattered, because a change of ownership had prevented Sovereign from carrying forward any net losses from a certain date.
At first instance, a significant issue was whether the second component (the commission receipts and repayments) could be unbundled from the treaty of which it formed part and taxed as a financial arrangement, notwithstanding Inland Revenue's acceptance that the first component of each treaty was a contract of insurance, and therefore fell outside the financial arrangements rules. This unbundling issue was decided in Inland Revenue's favour at first instance, and Sovereign conceded the point on appeal.
In the Court of Appeal, therefore, the case turned on whether Sovereign's receipt of commissions and making of commission repayments should nonetheless be taxed according to ordinary concepts (receipts are assessable on receipt, and commission repayments deductible on payment) leaving only the interest component subject to the timing rules in the financial arrangements rules.
The Court rejected Sovereign's argument to this effect, and held that once it was accepted that the financial arrangements rules applied to the commission repayments component, it followed that the gross receipts and refunds should not be recognised separately as income and expenditure. Rather the net amount should be recognised.
But two of the three judges then proceeded to consider how the amounts would be taxed under ordinary concepts, if (contrary to the Court's decision) ordinary concepts characterisation were relevant despite the financial arrangements rules applying. The two judges referred to the importance of the legal substance and concluded that the "essential legal character of the commission transactions" was that of a loan. The fact that Sovereign's obligation was to fund the commission repayments out of premiums received simply meant that the loan was a limited recourse one.
Long-standing decisions of the New Zealand courts confirm that, except when a different approach is required by the general anti-avoidance rule or other provision, arrangements must be characterised for tax purposes according to the legal arrangements actually entered into, not by reference to some economically or functionally equivalent arrangement. While it is unclear if the two judges intended to depart from these authorities, the approach taken does seem somewhat at odds with the established approach.
Subject to the outcome of any appeal to the Supreme Court, the case is significant on at least two levels. First, it provides support for comparable reinsurance arrangements to be taxed as loans in future. Ironically, this may in some circumstances provide a more favourable tax outcome for the parties (because of part of the reinsurer's profit being taxed more favourably as interest than as income from insurance). Second, it may signal a willingness on the part of the New Zealand courts to adopt a more substance-orientated approach to the characterisation of transactions for tax purposes than has previously been the case.
Greg Neill (firstname.lastname@example.org)
Tel: +64 9 367 8879
Fax: +64 9 336 5010
Mobile: +64 21 0260 5417
Brendan Brown (email@example.com)
Tel: +64 4 819 7748
Fax: +64 4 463 4503
Mobile: +64 21 245 6746
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