Taxman wins NZ$92.5 mln reinsurance dispute with Sovereign, which says judgement won't affect its credit rating but it's reviewing it

By Gareth Vaughan

Insurer Sovereign, sister company of ASB and a subsidiary of Commonwealth Bank of Australia, has lost a NZ$92.5 million High Court dispute with the Inland Revenue Department (IRD) over reinsurance arrangements.

Sovereign says it's reviewing the judgement and considering its response. The insurer also says it has notified its credit rating agency, A.M. Best, and doesn't believe the outcome will impact its A+ (superior) financial strength rating, which is an assessment of an insurer’s ability to meet obligations to policyholders.

In his judgement Justice Robert Dobson says the issue in the case is the appropriate treatment for tax purposes of components of reinsurance contracts, or treaties, entered into by Sovereign with three German reinsurers of life insurance risks being Gerling, Hanover Re and Cologne Re. He said the treaties provided for two sets of money flows between Sovereign and the reinsurers.

Firstly, Sovereign paid premiums to reinsure defined proportions of the mortality risk 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 was no dispute over the manner in which Sovereign accounted for the money flows in both directions on the reinsurance of those mortality risks.

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. Justice Dobson says 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.

Sovereign was obliged to repay the refundable commissions in stipulated portions out of 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.

'Interest component to compensate reinsurers'

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.  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 bonus account, says Justice Dobson.

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. 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 lapsed 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. 

"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," Justice Dobson says.

"However, the IRD 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 IRD 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."

Sovereign's challenge

Sovereign's response was that all money flows under the treaties were 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 had to be separately analysed, the components are each contracts of insurance, Sovereign argued.

"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 in the Act," says Justice Dobson.

"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)."

However, the IRD's fall-back position was if the accruals rules don't apply, then the character of the refundable commissions and commission repayments still has to be determined.

"On the IRD’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 IRD 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 IRD’s argument is misconceived."

In its annual financial statements for the year to June 30, 2011, Sovereign disclosed a contingent liability for the case.  The company said it had received assessments from the IRD in relation to the tax treatment of reinsurance arrangements in the 2000 to 2006 years. Sovereign had lodged High Court proceedings to challenge these reassessments. The IRD was expected to dispute the tax treatment of reinsurance arrangements in later years and to issue reassessments in respect of them in due course.

"Based on independent tax and legal advice, the company is confident the tax treatment it has adopted for the transactions is correct," Sovereign said.

"Should the IRD issue reassessments for all relevant tax years, the estimated maximum potential tax liability (including use of money interest and excluding penalties) as at June 30, 2011 would be NZ$71 million (as reported by interest.co.nz in 2010 this had stood at NZ$67 million as of June 30, 2010). The increase in the estimated liability since June 30, 2010 results from increased use of money interest," Sovereign said.

NZ$47.5 million plus interest of NZ$45 million

However, in his judgement Justice Dobson says the parts of the IRD's assessments being disputed result in additional tax liabilities for the plaintiffs of NZ$47.5 million. And, due to the lapse in time since the years in which the additional tax liabilities arose, there was also use of money interest assessed against Sovereign and sister companies of NZ$45 million.

Justice Dobson ruled that the commission arrangements ought 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."

"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."

"Against the contingency that I am wrong in upholding the IRD’s application of the accruals rules, then on the alternative contention for the IRD, 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," says Justice Dobson.

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