Financial arrangement rules trump accounting treatment

Sovereign Assurance Company v Commissioner of Inland Revenue [2012] NZHC 1760
This case underlines the broad scope of the financial arrangements rules.  The case concerned the tax treatment of a series of cash flows between Sovereign and foreign reinsurers recorded in a “Bonus Account”.
The facts of the case are complex.  Sovereign Assurance Company (“Sovereign”) issued life insurance policies and reinsured those policies with foreign reinsurers.  Sovereign paid premiums and the reinsurers paid out on claims made by Sovereign.  The premiums and claim payments were recorded in a “Bonus Account”.  Premiums paid by Sovereign were recorded as credits and claims paid to Sovereign as debits.  There was a second series of cash flows that were also recorded in the Bonus Account.  In the start up phase of Sovereign’s life insurance business, the refunds were used as a type of financing.  As Sovereign’s initial costs of issuing life insurance policies exceeded the premiums it received the reinsurers paid “refundable commissions” based on a multiple of the refundable commissions.  The amount included an interest component payable by Sovereign.  Payments to Sovereign of refundable commissions were recorded as debits in the Bonus Account.  Interest charges were treated as debits.
In a nutshell, payments made by Sovereign were recorded as credits in the Bonus Account, and the payments by the reinsurers as debits.  An excess credit balance constituted profit to Sovereign.
Sovereign treated the refundable commissions as income and the repayments as deductions.  Its treating the repayments of refundable commissions as deductible expenditure resulted in tax losses to Sovereign that were made available to other members of the group of Sovereign companies.  The basis for this treatment was that the refundable commissions formed part of the reinsurance arrangements and were therefore excluded from being financial arrangements under the excepted financial arrangements exclusion for insurance contracts. 
However, the Commissioner of Inland Revenue (“Commissioner”) disagreed with that treatment and assessed Sovereign on the basis that the refundable commissions and their repayment amounted to a financial arrangement.  The consequence was that the Commissioner treated the refundable commissions as a non-taxable receipt and only the portion of repayments in excess of the amount received by Sovereign were treated as deductible, spread over the life of the arrangement.
Sovereign rejected that treatment.  Critical to this position was the assertion by Sovereign that the refundable commissions formed an integral part of the insurance contract and could not be separated.  On that basis, Sovereign treated the cash flows relating to the refundable commissions in the same way as those from the premiums and claim receipts.  To support its position, Sovereign relied on the Court of Appeal decision in Marac Life Assurance Limited v Commissioner of Inland Revenue [1986] 1 NZLR 694 (CA).  Marac issued life bonds containing both investment and life insurance components.  The Court held that the investment component could not be separated from the life component.  The receipts in relation to the life component were exempt from income tax under the legislative provisions relevant at that time, and therefore the receipts for the investment component were also exempt.
Sovereign also argued that the refundable commissions were part of its reinsurance arrangements for accounting purposes.  Sovereign relied on the provisions in NZ IFRS 4 (that standard restricts the categories of transactions that can be treated as insurance contracts to those that involve a significant insurance risk) and specifically a provision in that standard that prohibits unbundling if an insurer cannot measure a “deposit component” separately.  However an expert witness for the Commissioner was firmly of the opinion that a true and fair view required Sovereign to treat the refundable commissions as a financing arrangement, and that such treatment was required to comply with NZ IFRS 4.
The Commissioner maintained that the refundable commissions were a financial arrangement and therefore the receipts were not income and the payments were deductible only to the extent of the interest element.  This would impact Sovereign greatly as a recent shareholding change meant that deductions available in earlier years due to the receipts not being income could not be carried forward and used.  The disallowance of the deductions would result in a tax liability of $45m as well as interest of around the same amount.
In the High Court, Dobson J found in favour of the Commissioner.  His Honour found that the refundable commissions and the repayment thereof amounted to a financial arrangement and the repayments were deductible only to the extent of the interest element.  In doing so he made some key observations about the operation of the financial arrangements rules.
1.    The scope of the financial arrangement rules is very broad.  In making this observation, Dobson J quoted New Zealand Accrual Regime – a Practical Guide (2nd edition, CCH, Auckland 1999):
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.

2.    A single agreement (such as the reinsurance agreement in Sovereign’s case) can be separated into two or more components for the purposes of the accrual rules.  Section EH 4 of the Income Tax Act 1994 (which defines “financial arrangement”) is couched in broad terms and Dobson J noted that an arrangement that may contain a debt or debt instrument, or an excepted financial arrangement.
His Honour noted further that a number of features "point to a process for deconstructing component parts of wider arrangements, so as to apply the accrual 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.  The features were:

a.    The definition of "financial arrangement" contains an exclusion for excepted financial arrangements where they are not part of a financial arrangement; and
b.    The definition of "financial arrangement" contemplates the inclusion of an excepted financial arrangement in an "arrangement", then excludes an excepted financial arrangement that is not part of a financial arrangement; but
c.    The exclusion under EH 2 is limited to items that are "solely attributable" to an excepted financial arrangement that is part of a financial arrangement.
His Honour noted further that:
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.

Finally, His Honour noted that the concepts of “deemed” income and expenditure are consistent with separately identifying and dealing with financial arrangements for tax purposes. He stated at paragraph 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.

3.    Dobson J concluded that the prescribed tax treatment under the financial arrangement rules overrides any accounting treatment adopted by Sovereign.  The prospect of treating money flows differently for financial reporting and accounting purposes was recognized by the Court of Appeal in both CIR v National Bank of New Zealand (1976) 2 NZTC 61,150 and CIR v Farmers Trading Company Ltd (1982) 5 NZTC 61,200 to the effect that accounting principles should apply “except so far as the statutory provisions require otherwise”.

His Honor noted the following:

a.    Effecting the purpose of the Income Tax Acts may require treatment of money flows in a manner that is different from presentation of those items in a manner intended to optimise the true and fair view of the financial state of the reporting entity;
b.    The statutory terms of the accrual rules remained constant throughout the years to which the relevant assessments relate, but the accounting standards relied on were changed.  It would be obtuse to adopt accounting standards that might produce different results in different years, when the accrual rules, if they applied, ought to require consistent results; and
c.    The requirement for consistency of treatment of transactions for the purpose of financial reporting is important because of the need for constant measures, especially in comparisons from one accounting period to another.  That consideration does not arise when deconstructing a larger arrangement for the purposes of applying the accruals rules.
4.    Whether or not a component of a financial arrangement is an excepted financial arrangement needs to be considered in terms of the statutory definition of the particular arrangement, if there is one, or if not, the definition of the concept applying more generally at common law should be used.  In this case, there is no definition of “contract of insurance” in the Act, so the common law definition applied.  Dobson J found that at some point the conversion of risk had lapsed to a point where it was no longer significant.  
5.    The underlying components of the financial arrangement may be income under ordinary concepts.  For example, a sale of revenue account property for a deferred consideration would give rise to tax implications in terms of both the financial arrangements rules and under general tax provisions.  However, that did not apply in this case, as the receipt of the commissions and the repayment thereof without a deferral would have merely amounted to a swap with no general tax consequences.

It is not surprising that this decision has been appealed.  The foundation for the decision that the commission element of the arrangement was a financial arrangement (i.e. that it was not an insurance arrangement) ignores the fact that the same part of the arrangement was happily treated as an insurance arrangement initially due to lapse risk.  As there was very little, if any, lapse risk towards the end of the arrangement, Inland Revenue claimed that the arrangement was no longer an insurance contract.  This begs the question as to how an arrangement can start life as an insurance arrangement and then, when the risk diminishes; it is no longer an insurance arrangement. 

The wider outcome of the case only gives rise to a timing issue, as the correct tax position is reached in the long term.  One may argue that the reason this case has been actively pursued by Inland Revenue because of the factual circumstances of this case; that is, the shareholding change that limited loses.  If there had not been a shareholding change, I question whether Inland Revenue would have pursued this case.

© G D Clews

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