New Zealand statutory context in brief

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1 Australian TOFA implications for insurers from the NZ Sovereign Assurance case by Joanne Dunne, CTA, Partner, and James Hamblin, CTA, Senior Associate, Minter Ellison, Melbourne Abstract: Decisions of the New Zealand courts in the Sovereign Assurance case considered the application of New Zealand s taxation of financial arrangements (TOFA) rules to reinsurance treaties entered into by a New Zealand insurer. The New Zealand rules parallel Australia s TOFA regime in Div 230 of the Income Tax Assessment Act 1997, and New Zealand cases therefore have relevance in Australia. This article first outlines New Zealand s financial arrangements rules, and the facts and main holdings in Sovereign Assurance. The authors then compare New Zealand s financial arrangements rules to the Australian TOFA rules and consider whether the result could have been different if it had been decided in Australia. The authors conclude that the case shows that even very longstanding arrangements which are commonly used by industry, such as reinsurance treaties, can lead to results under TOFA which may be unanticipated. Introduction In June 2014, a longstanding tax case, Sovereign Assurance Company Ltd and others v Commissioner of Inland Revenue 1 (Sovereign Assurance), was finalised in the New Zealand courts by the Supreme Court of New Zealand refusing to grant the taxpayer leave to appeal. Sovereign Assurance considered the application of New Zealand s taxation of financial arrangements rules 2 to reinsurance treaties entered into by a New Zealand insurer. New Zealand s financial arrangements rules are in Pt EW of the Income Tax Act 2007 (NZ) (ITA), and were enacted in the late 1980s. Much of the detail of New Zealand s rules is replicated in Australia s taxation of financial arrangements (TOFA) regime in Div 230 of the Income Tax Assessment Act 1997 (Cth) (ITAA97). There are differences of course, particularly in the complexity of the two sets of rules. 3 In this article, some context to New Zealand s financial arrangements rules is outlined (in brief), as well as the facts and main holdings in Sovereign Assurance. The controversial aspects of the decision in New Zealand are identified. New Zealand s financial arrangements rules are also compared to the Australian TOFA rules and it is considered whether the result could have been different if it had been decided in Australia. New Zealand statutory context in brief Like Australia s TOFA regime, New Zealand s financial arrangements rules are designed to require a recognition of income and expenditure over the term of a financial arrangement, using a number of potentially applicable methods depending on the financial arrangement involved. Section EW 1(3) ITA sets out the purposes of the financial arrangements rules: 4 (3) The purposes of the financial arrangements rules are (a) to require the parties to a financial arrangement to accrue over the term of the arrangement a fair and reasonable amount of income derived or expenditure incurred under the arrangement, and so to prevent the deferral of income or the advancement of expenditure; and (b) to require the parties to a financial arrangement to disregard any distinction between capital and revenue amounts; and (c) to require a party to a financial arrangement to calculate a base price adjustment when the rights and obligations of the party under the arrangement cease. The sentiments in s EW 1(3) are echoed in s ITAA97. 5 Like Australia s rules, New Zealand s financial arrangements are premised on there being a financial arrangement. The financial arrangements rules exclude some arrangements from the regime, such as particular excepted financial arrangements. The definition of excepted financial arrangement includes an insurance contract. 6 Australia s rules operate similarly, and exclude insurance contracts (subject to some exceptions). 7 The New Zealand definition of insurance contract in s YA 1 ITA is not restrictive, and typically brief as compared to the Australian equivalent definitions. It reads as follows: insurance contract includes a cover note and a renewal of an insurance contract. Insurance is defined for other purposes in the ITA, but not for the purposes of the financial arrangements rules and falls to be considered using its common law meaning. While excepted financial arrangements such as insurance contracts are excluded from the financial arrangements rules, s EW 6 ITA recognises that in some situations, an excepted financial arrangement can itself be a part of an overall financial arrangement. Section EW 6 provides that for some such excepted financial arrangements (including insurance contracts), amounts solely attributable to those arrangements are excluded from the ambit of the rules. 532

2 The approach in the Australian context under s (4) ITAA97 is only slightly different. Under that provision, the issue is whether the rights and obligations in an arrangement are themselves an arrangement or two or more arrangements. In addition, the TOFA exceptions are generally defined by reference to particular rights and obligations, as opposed to considering whether an exception can subsist within a financial arrangement. In terms of the priority given to the financial arrangements rules, s EW 2 provides that the New Zealand financial arrangements rules prevail over any other provision of the ITA, unless it is specified otherwise. Similarly, ss to ITAA97 provide that gains and losses are only to be taken into account once under the ITAA97 and that gains and losses assessable or deductible under the TOFA rules cannot be assessed or deducted under any other provisions. However, the ITAA97 provisions also provide that generally where income or expenditure would have been non-assessable, non-exempt or exempt under other provisions of the ITAA97, that status is retained. This means that the primacy of TOFA may not be as clear-cut as under New Zealand s financial arrangements rules. Facts in the case Sovereign Assurance is a New Zealand resident life insurance company. It entered into three reinsurance treaties with German-based reinsurers. In broad terms, each reinsurance treaty involved two sets of money flows: (1) Sovereign Assurance paid premiums to reinsurers to reinsure defined proportions of mortality risk. The reinsurers accepted liability to meeting the cost of defined proportions of claims made under those policies; and (2) the reinsurers agreed to pay Sovereign Assurance refundable commissions, which were calculated as a multiple of the initial premiums received by Sovereign Assurance on the life insurance policies it had issued. Sovereign Assurance was required to repay the refundable commissions to reinsurers out of the subsequent years premiums, as long as the life insurance policies at issue remained in force. The refundable commissions amounts repayable by Sovereign Assurance included an interest element to reflect the time value of the commissions paid by the reinsurers to Sovereign Assurance. If a policy holder did not pay Sovereign Assurance premiums on a reinsured policy and/or the policy lapsed, Sovereign Assurance was not obliged to repay refundable commissions to the reinsurers in respect of that policy. As a consequence, the second set of money flows provided Sovereign Assurance coverage for lapse risk. The arrangements under each reinsurance treaty were recorded in an account which the case refers to as the bonus account. The bonus account kept track of the money flows between Sovereign Assurance and the reinsurers. Reinsurance premiums and repayments of refundable commissions paid by Sovereign Assurance to reinsurers were credited to the bonus account, claims and refundable commissions paid by the reinsurers to Sovereign Assurance were debited to the bonus account. Any interest charge on outstanding commissions was also debited to the bonus account. In broad terms, over time, the reinsurers would be repaid refundable commissions plus interest. 8 Commercially, the second set of money flows in the reinsurance treaties acted as a form of financing for Sovereign Assurance. It was common ground before the New Zealand courts that the refundable commission arrangements assisted Sovereign Assurance to fund new business. The second set of money flows was at issue in the case. Tax treatment adopted by Sovereign Assurance and the competing arguments Sovereign Assurance had accounted for the second set of money flows in its tax returns on a very straightforward basis. The refundable commissions received from reinsurers were treated as income in the year they were receivable, and the repayments of the refundable commissions (including the interest element) were treated as deductible expenses in the year they were payable. Sovereign Assurance took the view that the reinsurance treaties were excepted financial arrangements being contracts of insurance, and the financial arrangements rules did not apply. Sovereign Assurance s tax treatment of the second set of money flows led to tax losses which were offset against income which arose to other members of the Sovereign Assurance group of companies. 9 The Commissioner took the view that the second set of money flows was a financial arrangement. Amended assessments were issued for the 2000 to 2006 income years under the financial arrangements rules. 10 The amended assessments treated the refundable commission payments received by Sovereign Assurance from reinsurers as a receipt of principal, and only the interest portion of the repayments made by Sovereign Assurance to reinsurers as deductible, with that deduction spread over the life of the arrangement using a method under the financial arrangements rules. Because there was a change of ownership of Sovereign Assurance in 1998, 11 the Commissioner s assessments had an impact on the wider group. New Zealand does not have a test similar to the same business test, and only has a continuity of ownership test for the carry forward of tax losses. Continuity was breached in The overall effect of the Commissioner s assessments was to disallow tax losses claimed by Sovereign Assurance in the income years, disallowing the offset of those losses by members of Sovereign Assurance s group, thereby increasing taxable income of other members of the group. The Commissioner also took the alternate position that if the financial arrangements rules did not apply, the refundable commissions received by Sovereign Assurance were arguably not derived as there was an obligation to repay them. In addition, the Commissioner maintained that those money flows comprised in substance a loan, and were capital obligations which meant that their receipt and repayment was of a capital nature and not assessable or deductible, other than insofar as the interest element was concerned. In response, Sovereign Assurance maintained: the money flows under each reinsurance treaty could not be unbundled as they comprised one arrangement, being an insurance contract outside the scope of the financial arrangements rules. Operationally, each set of money flows was heavily interdependent as both sets of money flows originated from premiums paid for insurance policies. Sovereign Assurance also pointed to accounting standards which required all money flows to be accounted for in unbundled form; if, contrary to the above, both sets of money flows could be unbundled, the TAXATION IN AUSTRALIA VOL 49(9) 533

3 two sets of money flows were each an insurance contract outside the scope of the financial arrangements rules; and if, contrary to both of the above, the second set of money flows was a financial arrangement, the financial arrangements rules only applied to spread the interest portion of the refundable commissions, with the remainder of the money flows being dealt with under the core provisions of the ITA. Applying those principles, the refundable commissions were assessable income which offset the costs of establishing the life insurance policies, while the commission repayments were deductible expenses. Judgments in the New Zealand courts Whether the reinsurance treaties could be unbundled and the first and second sets of money flows treated separately At first instance, the High Court held that the reinsurance treaties could be unbundled and that the second set of money flows could be separated from the first. The court held that the question to be considered was whether the two sets of money flows in each reinsurance treaty were capable of separation. In holding that the two sets of money flows in the reinsurance treaties could be considered separately, Justice Dobson: held that the provisions in the financial arrangements rules expressly contemplate that one overall wider arrangement can be comprised of one or more financial arrangements and/or excepted financial arrangements; 12 held that the evidence from the Commissioner was preferred. That evidence was to the effect that reinsurers could consider entering into an arrangement comprising just one or the other of the two sets of money flows. This suggested capability of separation; was not satisfied that the form of the contractual arrangements provided an impediment to the capability of separating the two sets of money flows; was not satisfied that the treatment of reinsurance treaties as one arrangement in other jurisdictions both commercially and for tax purposes was persuasive in the context of the financial arrangements rules; and held that the financial arrangements rules override accounting treatment. While the accounting treatment may have required the two sets of money flows to be considered together (this was disputed in competing evidence), that was not determinative for tax purposes. Facts such as that accounting standards had changed but the financial arrangements rules had not were considered persuasive in this context. This aspect of the decision has given rise to some commentary, in particular whether, when considering whether the second set of money flows could be unbundled, the test in the financial arrangements rules requires consideration of the actual contractual arrangements entered into as opposed to what might have been entered into. In addition, commentary has also focused on whether, when concluding the second set of money flows was akin to a financing arrangement, Justice Dobson was taking an impermissible approach of applying economic substance outside of the general anti-avoidance rule, when case law required consideration of the actual legal arrangements entered into. 13 This aspect was not the subject of appeal in the Court of Appeal. It is not entirely clear why it was not appealed. The authors understand that there may have been some evidential difficulties. Whether the second set of money flows treated separately was an insurance contract At first instance, Justice Dobson also held that the second set of money flows in each reinsurance treaty was not an insurance contract and therefore fell within the financial arrangements rules. Justice Dobson turned to the common law to determine the meaning of the term insurance. He held that the second set of money flows was not an insurance contract primarily because it did not involve the payment of a premium by Sovereign, and a premium was required before there would be an insurance contract. Justice Dobson also examined whether another feature of an insurance contract, the transfer of risk, was present. He held that while lapse risk may have been transferred, this was only so significantly in the early years of the arrangement. Looking at the arrangement as a whole over its entire term, the operation of the bonus account meant there was no significant lapse risk transfer, and there was little risk that the bonus account would not reach a credit balance. Justice Dobson also did not accept there was a timing risk (ie the risk that premiums would be received later than expected) transferred by the second set of money flows. These aspects of the decision have also given rise to some commentary. In particular, the idea that at early stages of the arrangement lapse risk was transferred (so arguably the arrangement was an insurance contract ), while at latter stages it was not. It seems unusual that there could have been an insurance contract one day and not the next, depending on a view of whether the risk transferred was significant. 14 The question of whether the second set of money flows was a financial arrangement was not the subject of appeal in the Court of Appeal. What was the subject of appeal was whether, even if it was a financial arrangement, only the interest element was required to be spread under the financial arrangements rules, with the remaining cash flows being treated as income and expenditure in accordance with ordinary principle. The Court of Appeal dismissed the submission that the financial arrangements rules only impacted on the interest element and held that the financial arrangements rules required all cash flows to be taken into account, with the difference between the money provided and that received by Sovereign Assurance (ie the interest element) being spread over the term of the arrangement. The Court of Appeal also rejected an argument that the second set of cash flows was an excepted financial arrangement as a transfer of property, pursuant to the terms of a former provision applicable at the time of the Sovereign matter, but which is no longer in the financial arrangements rules. Treatment of the second set of money flows under ordinary principle, assuming they were not a financial arrangement At first instance, Justice Dobson held that even if the financial arrangements rules did not apply, using ordinary principle, the second set of money flows were in the nature of financing and should be treated as such with the base component capital in nature, and the interest component was the only relevant component for tax purposes. 534

4 On appeal, in obiter, the majority of the Court of Appeal held that the arrangement needed to be considered in its commercial context, and the essential legal character of the second set of money flows was as a loan and it should be treated as such. Both holdings have been the subject of commentary in New Zealand as to whether, even absent the application of the general anti-avoidance rule, the New Zealand courts are now applying a substance based characterisation to arrangements for taxation purposes. 14 How would Sovereign Assurance have been treated under Australia s TOFA regime? 15 Whether the reinsurance treaties could be unbundled and the first and second sets of money flows treated separately When applying the TOFA rules, the first step is to define the parameters of the financial arrangement to be examined. While this step is often straightforward, the facts of Sovereign Assurance pose the difficult question of whether the first set of money flows and the second set of money flows are to be treated together or separately. Section (4) provides that whether one or more arrangement exists is a question of fact and degree having regard to factors including the nature of the rights and obligations, their terms and conditions, the circumstances surrounding their creation, whether they can be dealt with separately, normal commercial understandings and the objects of Div 230. The Commissioner provides guidance as to the application of s (4) in TR 2012/4. As a starting point, the rights and obligations under a particular contract will often form a single arrangement. 16 As was argued by Sovereign Assurance before the New Zealand High Court, the fact that both sets of money flows formed part of one reinsurance treaty suggests there is a single arrangement. An Australian resident Sovereign Assurance could contend that the treaty constituted one single arrangement where the components could not be separated. Supporting that, in relation to the second set of money flows relating to the refundable commission arrangements, is the fact that commissions payable by the reinsurers were calculated with reference to the premiums received by Sovereign Assurance on life insurance policies that it reinsured. There is an interconnection. An Australian Sovereign Assurance could also draw support from note 1 to s , which states that: If you raised funds by means of a contract that you would not have entered into without entering another contract, and neither contract could be assigned to a third party without the other also being assigned, this would tend to indicate that your rights and obligations under the 2 contracts together constitute one arrangement. However, the legal form of rights and obligations will not necessarily be determinative. An Australian Sovereign Assurance could also submit that the fact that both sets of money flows were treated together for accounting purposes was consistent with the normal commercial understanding that they would be treated as one arrangement. When applying the TOFA rules, the first step is to define the parameters of the financial arrangement to be examined. In response, like the New Zealand Inland Revenue, the Commissioner could highlight that reinsurance and commission rights and obligations could be dealt with separately and each stand as commercial arrangements in their own right. Sovereign Assurance could have theoretically entered separate arrangements, including potentially refundable commission arrangements with a party other than the reinsurer (although such a separate arrangement might be more likely to be conventional lending). Accordingly, while the two components may have been commercially linked, they could be said to not be intrinsically linked. Further, it has long been held that accounting treatment is not determinative of tax treatment. 17 In New Zealand, Sovereign Assurance cited the Australian Full Federal Court decision in Australia and New Zealand Savings Bank Ltd v FCT. 18 In that case, the court respected the legal form of an annuity and rejected the argument that a doctrine of substance should be invoked to treat the instrument as part annuity and part repayment of capital with interest. Sovereign Assurance sought to use this case to support its view that the reinsurance treaties should not be unbundled. The Australian Commissioner could seek to distinguish this case and conclude (as the New Zealand courts did) that the reinsurance treaties comprised two separately identifiable series of money flows that reflect different and discrete (if overlapping) commercial dynamics. 19 The above is by no means an exhaustive discussion of potential arguments on this point. It serves to demonstrate the difficulty that can arise when determining whether there is one or more financial arrangement under TOFA. The position of whether there is only one or two arrangements in the context of reinsurance treaties, such as those considered in New Zealand, remains arguable in Australia. Nevertheless, in order to illustrate the Australian TOFA issues, the analysis which follows proceeds on the assumption that the reinsurance treaties were comprised of two separate arrangements. Application of the TOFA insurance exceptions to the first set of money flows Rather than taking the New Zealand approach of specifying a class of excepted financial arrangements, the Australian TOFA rules do not apply to gains or losses from a financial arrangement to the extent that particular types of rights and obligations are the subject of an exception. 20 Rights and obligations under a life insurance policy or a general insurance policy are generally excepted from the operation of Div 230. Section (5) and (6) provide: TAXATION IN AUSTRALIA VOL 49(9) 535

5 (5) A right or obligation under a *life insurance policy is the subject of an exception unless: (a) (b) you are not a *life insurance company that is the insurer under the policy; and the policy is an annuity that is a *qualifying security (6) A right or obligation under a *general insurance policy is the subject of an exception unless: (a) (b) you are not a *general insurance company; and the policy is a *derivative financial arrangement. The ITAA97 defines a life insurance policy by reference to the Life Insurance Act 1995 (Cth), and that Act includes most types of contracts of insurance that provide for payment on the death of a person or on the happening of a contingency dependent on the termination or continuance of human life (among other things). 21 Sovereign Assurance paid premiums under the reinsurance treaties to reinsure defined proportions of mortality risk, and this is the first set of money flows under the treaties. The ITAA97 does not provide that a contract cannot be a life insurance policy if it calculates payments by reference to a portfolio of underlying policies rather than to a single stand-alone policy. At least this first component of Sovereign Assurance s reinsurance treaties should meet the definition of a life insurance policy for the purposes of the ITAA97. Applying s (5)(a), even though Sovereign Assurance is hypothetically an Australian life insurance company, it was not the insurer under the policy (the reinsurer was the relevant insurer for the purposes of this provision). However, s (5)(b) must also apply in order for the exception from the TOFA regime to not be applicable. Clearly, the reinsurance treaties were not annuities that were qualifying securities. This means that, to the extent that an Australian resident Sovereign Assurance s rights and obligations were in respect of the first component of the reinsurance treaties, gains and losses attributable to such rights and obligations should not be subject to Div 230. This is the same conclusion as reached in the New Zealand courts where the first set of money flows was held to be an insurance contract. For completeness, for the purposes of the similar exception contained in s (6), a general insurance policy is defined as a policy of insurance that is not a life insurance policy or an annuity instrument. 22 The term policy of insurance is not defined and therefore takes its ordinary meaning as noted in the explanatory memorandum to the Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2008 (Cth) (TOFA EM), it can include a policy of reinsurance. 23 Assuming that the TOFA provisions do not apply to the first set of money flows under the reinsurance treaties, Div 320 (together with s 148 of the Income Tax Assessment Act 1936 (Cth) (ITAA36)) is relevant. Application of Div 320 ITAA97 and s 148 ITAA36 to the first set of money flows Division 320 was introduced with effect from 1 July 2000 to ensure that life insurance companies would be taxed on a more rational basis in line with the treatment of similar activities by other entities. 24 To this end, the Division specifies particular items that must be included in the assessable income of a life insurance company. 25 In particular, s provides that, unless an amount relates to a risk, or part of a risk, in relation to which s 148(1) ITAA36 applies, the following are included in the assessable income of a life insurance company (among other things): (1) amounts received or recovered under contracts of reinsurance to the extent to which they relate to risk components of claims paid under life insurance policies; and (2) any amount received or recovered that is a refund, or in the nature of a refund, of the life insurance premium paid under a contract of reinsurance. 26 The original version of s 148(1) ITAA36 was enacted in 1938 in response to difficulties in assessing and collecting tax from non-resident reinsurers. It provides that, where a taxpayer carries on the business of insurance in Australia and reinsures the whole or part of any risk with a non-resident: (1) premiums paid or credited shall not be deductible to the taxpayer or assessable to the non-resident; and (2) sums recovered in respect of a loss on any risk reinsured will not be assessable to the taxpayer. In effect, the subsection provides a mechanism for the Australian resident party to the reinsurance contract to bear what would otherwise be the non-resident s tax burden (or obtain the tax benefit) associated with the arrangement. However, s 148(1) ITAA36 has limited application to life insurance companies. Section 148(10) ITAA36 states that s 148 applies to life insurance companies only if the reinsured risk is covered by a disability policy. 27 Further, an insurance company can elect for s 148(1) not to apply and instead lodge returns and pay tax as agent for the non-resident reinsurer. 28 Therefore, assuming that s 148(1) ITAA36 does not apply to the Australian resident Sovereign Assurance, Div 320 should operate to tax amounts received or recovered in respect of the first set of money flows under the reinsurance treaties. Division 320 provides symmetry by allowing a deduction for premiums under contracts of reinsurance when paid. 29 Importantly, premiums will not be deductible if the arrangement does not transfer risk to the reinsurer, as the arrangement would not be a contract of reinsurance as defined. 30 Application of the TOFA insurance exceptions to the second set of money flows Whether a TOFA insurance exception could apply to the second component of the reinsurance treaties, the refundable commission arrangements, is less clear. The application of the Australian TOFA exception in s (5) depends on whether commissions paid or received can be said to be in respect of rights or obligations under a life insurance policy. In effect, this is a different way of approaching the same question as was considered by the New Zealand courts which was whether there were two financial arrangements within the one treaty. So, even if the reinsurance treaties were considered one financial arrangement, s (5) could impact on the refundable commission arrangements. As noted above, the reinsurance treaties should meet the definition of a life insurance policy. However, neither Div 230 nor the TOFA EM provide guidance as to the circumstances in which a right or obligation is under a life insurance policy. The Australian courts have considered similar phrases and, unsurprisingly, have held that the meaning of an expression of this nature requires reference to the particular context in which the expression appears. 31 For example, in Australian Finance Direct Ltd v Director of Consumer 536

6 Affairs Victoria, 32 Kaye J noted the following in relation the phrase under the contract : Generally that phrase has been construed so that, in order that a payment be made or an obligation arise under the contract, the contract must be the source of the relevant payment or obligation. Each of Sovereign Assurance s reinsurance treaties contained both sets of money flows in the same contract. In relation to the second set of money flows, relating to the refundable commission arrangements, it is notable that commissions payable by the reinsurers were calculated with reference to the premiums received by Sovereign Assurance on life insurance policies that it reinsured. It could be argued that the life insurance policy was literally the source of the commission rights and the second component of the reinsurance treaties was excepted from TOFA under s (5). In the alternative, Sovereign Assurance could argue (as it did in the New Zealand High Court) that the refundable commission arrangements were a general insurance policy for the purposes of the exception in s (6), as they effectively provided it with coverage for lapse risk. While Justice Dobson held that there was no significant lapse risk transfer because risk reduced over time, it is arguable that even if risk reduces or changes over time, that does not mean that the arrangement is not an insurance policy. There is also an issue as to what significant risk transfer would comprise and what level of risk transfer is acceptable to comprise insurance. If a similar approach was taken under TOFA, potentially a large range of products would also not be considered insurance. However, as Sovereign Assurance is not a general insurance company, 33 the exception in s (6) would not apply if the refundable commission arrangements could be characterised as a derivative financial arrangement as defined in s The phrase derivative financial arrangement generally connotes instruments commonly used for hedging (eg swaps, options, forwards and futures). However, the definition in s is broader than that and includes all financial arrangements that have: (1) a value which changes in response to changes in a specified variable or variables; and (2) no requirement for a net investment, or if there is such a requirement, the net investment is smaller than would be required for other financial arrangements that would be expected to have a similar response to changes in market factors. Arguably, the value of the refundable commission arrangement changes based on the timing and amount of premiums received by Sovereign Assurance on the underlying policies, and whether premiums are received at all by Sovereign Assurance. For this reason, it could possibly be argued that the value of the refundable commission arrangements changes due to such variables. However, no such variable or variables are specified as is required by s For that reason, it is arguable that the refundable commission arrangements are not a derivative financial arrangement, and that the second set of money flows is a general insurance policy and excluded from TOFA. If either of the insurance exceptions to TOFA applies to the second set of money flows under the treaties, s should apply to Sovereign Assurance. Section provides that, unless an amount relates to a risk, or part of a risk, in relation to which s 148(1) ITAA36 applies (refer above), the following are included in the assessable income of a life insurance company: (1) any reinsurance commission received or recovered by the company in respect of a contract of reinsurance; and (2) any amount received under a profit-sharing arrangement contained in, or entered into in relation to, a contract of reinsurance. 35 Division 320 does not contain a specific provision which would allow Sovereign Assurance a deduction for the repayment of commissions received. Sovereign Assurance may need to argue that such payments were not of a capital nature and therefore deductible under s 8-1. However, the application of either of the TOFA insurance exceptions to the second set of cash flows in the treaties is not assured and the answer to this question is not clear cut. If the insurance exceptions to TOFA did not apply, Div 320 would obviously not apply to the refundable commissions arrangements. 36 Application of TOFA to the second set of money flows If the TOFA insurance exceptions did not apply to the second set of money flows, Sovereign Assurance s gain or loss under the refundable commission arrangements should be taken into account under TOFA using one of the default accruals or realisation methods, or one of various elective methods. As a life insurance company, Sovereign Assurance may choose one or more elective methods, however a discussion of these is beyond the scope of this article. As Sovereign Assurance s gain or loss from the refundable commission arrangement was (at least in part) contingent on the volume and timing of receipts of premiums on the underlying reinsured policies, there could be no sufficiently certain overall gain or loss that could be determined at the time of entry into the reinsurance treaty. 37 However, the accruals method should apply with respect to sufficiently certain particular losses of Sovereign Assurance, being the interest levied on refundable commissions received. This would mean that Sovereign Assurance should deduct interest on a compounding accruals basis over the period to which it relates. 38 Consistent with New Zealand s financial arrangements rules as interpreted by the New Zealand Court of Appeal, the TOFA rules require all financial benefits under a financial arrangement to be taken into account. Accordingly, an Australian Sovereign Assurance should not be able to deduct the commission principal as it was repaid, and similarly it should not be assessed on receipt. As a result, the same outcome that arose in the New Zealand Court of Appeal seems likely to have arisen in the Australian context if TOFA was applicable. Conclusion New Zealand provides useful precedent for Australian TOFA. Although there are some differences, there are broad similarities between the financial arrangements rules in New Zealand and the TOFA regime. Australia awaits its first case on the TOFA regime. New Zealand s experience shows that very few cases arise in the courts. The Sovereign Assurance case shows that even very longstanding arrangements which are commonly used by industry, such as reinsurance treaties, can lead to results under TOFA which may be unanticipated. The experience in New Zealand suggests that care should be taken by insurers to take advice and/or seek guidance from the ATO, before concluding that all aspects of such reinsurance arrangements are excluded from TOFA. In the context of the insurance exceptions to TOFA, in light of Sovereign TAXATION IN AUSTRALIA VOL 49(9) 537

7 Assurance, further guidance from the ATO could prove valuable in relation to arrangements that commonly form part of reinsurance treaties, such as refundable commission arrangements. Joanne Dunne, CTA Partner Minter Ellison, Melbourne James Hamblin, CTA Senior Associate Minter Ellison, Melbourne References 1 [2012] NZHC 1760 (High Court of New Zealand equivalent level to the Federal Court of Australia), [2013] NZCA 652 (Court of Appeal of New Zealand equivalent level to the Full Federal Court of Australia), [2014] NZSC 68 (Supreme Court of New Zealand equivalent level to the High Court of Australia). 2 The New Zealand rules were enacted in the 1980s and are known as the financial arrangements rules, and will be referred to as such in this article. Prior to the rewrite of the ITA, New Zealand s rules were known as the accrual rules or accruals rules and this is the reference used in the Sovereign Assurance decisions. In this article, the current term for New Zealand s rules is used. 3 Australia wins on complexity. 4 The base price adjustment is the equivalent of the balancing adjustment in TOFA. 5 Section (b) ITAA97 provides for the alignment of tax and commercial recognition. One of the potentially available spreading methods under New Zealand s financial arrangements rules is the IFRS financial reporting method (modified in some circumstances), aligning the tax and accounting recognition of gains and losses. 6 Note, the ITA is the result of a rewrite of the former Income Tax Act 2004 (NZ) and the even earlier Income Tax Act 1994 (NZ). The 1994 Act and 2004 Act provisions were at issue in the Sovereign Assurance case and the 1994 Act provisions referred to a contract of insurance as opposed to an insurance contract. There were no substantive changes in the rewrite process to this area of the ITA so the current NZ legislation is referred to in this article. Following the Sovereign Assurance case, amendments were made to New Zealand s regime to exclude from the insurance contract exclusion life financial reinsurance (as defined). That amendment was not applicable in the years at issue in the case and was effective from 1 July Section (5) ITAA97 excludes a right or obligation under a life insurance policy (with exceptions), and s (6) excludes a right or obligation under a general insurance policy (with exceptions). These exceptions are discussed later in this article. 8 This would be the position only as long as the total business between the reinsurers and Sovereign Assurance was sufficient to make up for any deficit from lapsed policies, and also any deficit between premiums paid by Sovereign Assurance and any claims under the reinsured policies. 9 It is not clear from the case whether the group was a consolidated tax group, or merely grouped for the purposes of tax losses both options are provided for under the ITA. 10 Since 1994, the New Zealand rules have required the statutory dispute resolution procedures to be completed before amended assessments can be issued by the Commissioner. These procedures involve the exchange of statutorily prescribed documents in statutorily prescribed timeframes. In any proceedings, the taxpayer and the Commissioner are limited to their legal grounds and (at the time of these assessments) also the evidence in the last of those documents, a document known as the statement of position. What was formerly known as the Adjudication Unit, an independent unit within Inland Revenue, then considers those documents and determines whether or not amended assessments will be issued. If assessments are issued, there is no objection process and for the matter to be disputed, the taxpayer must file proceedings. This process is essentially front-end dispute resolution and discussions between the Inland Revenue and taxpayer to a pre-assessment phase. 11 This is when it was purchased by ASB Bank Limited, a Commonwealth Bank of Australia subsidiary. 12 This includes, for instance, s EW 6 ITA, noted above, which contemplates an excepted financial arrangement and a financial arrangement being together part of one overall arrangement. 13 See, for example, B Brown, Case law developments, paper delivered to the 2012 New Zealand Institute of Chartered Accountants Tax Conference. 14 See, for example, G Clews, Barrister, Financial arrangement rules trump accounting treatment, New Zealand tax case notes All statutory references are to the ITAA97 unless otherwise stated. 16 As stated at para 2.49 of the TOFA EM and acknowledged by the Commissioner in para 6 of TR 2012/4. 17 See, for example, Commissioner of Taxes (South Australia) v The Executor, Trustee and Agency Company of South Australia Ltd (1938) 63 CLR Australia & New Zealand Savings Bank Ltd v FCT [1993] FCA [2012] NZHC 1760 at [91]. 20 S (1) ITAA S 995-1(1) ITAA97 and s 9 of the Life Insurance Act 1995 (Cth). 22 S 995-1(1) ITAA Para of the TOFA EM. At a high level, this suggests that reinsurance arrangements were intended to be captured by the exceptions to the TOFA regime. 24 Para 5.7 of the explanatory memorandum to the New Business Tax System (Miscellaneous) Bill (No. 2) 2000 (Cth). 25 S ITAA S (1)(b) and (c) ITAA97. Broadly, s defines the relevant risk components as the amount paid on the occurrence of death or disability of the insured person (and allows a deduction for this amount). Also, note that a contract of reinsurance does not include a contract of reinsurance in respect of certain exempt life insurance policies or the parts of the complying superannuation/fhsa life insurance policies in respect of which the liabilities of the company that issued the policies are to be discharged out of a complying superannuation/fhsa asset pool. 27 As defined in s 995-1(1) ITAA S 148(2) to (9) ITAA S ITAA As discussed in TR 96/2 and at para 5.95 of the explanatory memorandum to the New Business Tax System (Miscellaneous) Bill (No. 2) 2000 (Cth). 31 For example, see Thurn v FCT (1965) 112 CLR 432 at 437; Chan v Cresdon Pty Ltd (1989) 168 CLR 242 at 249; and FCT v Energy Resources of Australia (1994) 54 FCR 25 at 53 and [2004] VSC The s 995-1(1) ITAA97 definition of this term refers to the term insurance business in the Insurance Act 1973 (Cth), which carves out life insurance businesses. For the purposes of this article, it is assumed that Sovereign Assurance offers only life insurance. 34 It is possible that the reinsurance treaties have a specific term relating to the non-receipt of premiums from underlying policy holders. If that variable then affected the value of the refundable commission arrangements, that could suggest that insofar as the refundable commissions arrangement component of the treaties is concerned, it could be a derivative financial arrangement. For the purposes of this article, both options are considered in relation to the TOFA insurance exceptions, ie that a TOFA insurance exception does apply or does not apply to the second set of cash flows. 35 S (1)(ca) and (d) ITAA Section (2) states that a financial benefit is not to be included in a taxpayer s assessable income outside of Div 230 if it has been taken into account in determining a gain or loss under that Division. 37 As determined under s ITAA Or a method which approximates compounding accruals: s (2) ITAA