R.A.C. Insurance Pty. Ltd. v. Federal Commissioner of TaxationJudges:
Full Federal Court
Davies, Wilcox and French JJ.
This is an appeal from a judgment of a single Judge of the Court [reported at 89 ATC 4780]. His Honour upheld the substance of the Commissioner's decisions on objections lodged by the appellant, R.A.C. Insurance Pty. Ltd. (``R.A.C. Insurance''), against assessments to tax for the years ended 30 June 1983 to 30 June 1986. The assessments, relying on sec. 25(1), 26(a) and 25A of the Income Tax Assessment Act 1936 (Cth) (``the Act''), included in the assessable income of R.A.C. Insurance certain profits made on the sale of the shares. His Honour allowed the appeal before him to the extent that sec. 23J of the Act applied. No issue arises with respect to that matter.
R.A.C. Insurance is a wholly-owned subsidiary of the Royal Automobile Club of Western Australia Inc. (``the club'') and was established for the benefit of the members of the club. The learned trial Judge set out the following relevant facts (at pp. 4782-4789):
``The taxpayer commenced business on 1 June 1947 as an insurer against damage to motor vehicles and against loss occasioned by personal injuries arising out of the use of a motor vehicle. The taxpayer's entry into business was immediately successful and it became one of the major insurers in Western Australia in respect of damage to motor vehicles despite the fact that the taxpayer limited such insurance to members of the club. In due course, the taxpayer's business expanded and in addition to providing insurance for motor vehicles the taxpayer insured dwellings and contents, power boats, special risks and travel risks.
Until March 1988 the taxpayer only offered insurance to club members, but after that date insurance of dwellings and contents was offered to the public.
Since commencing business the taxpayer has protected its exposure as an insurer by obtaining cover under reinsurance contracts. The amount of reinsurance required was assessed from year to year, but was usually between 1 per cent to 2 per cent of the total annual sum insured. The total annual sum insured was an estimate of the number of risks to be insured in that year and of the probable exposure thereunder. The amount of reinsurance obtained was that considered by the taxpayer to be a realistic assessment of the extent of the risk of the occurrence of a catastrophic event such as a major fire, cyclone or earthquake from which massive claims may result...
In conducting its insurance business, it was the longstanding policy of the taxpayer, as adopted by its board of directors, to endeavour to provide for the underwriting activity of the business to be run at a break-even level or at a small profit. It was not the policy of the board to augment the taxpayer's underwriting activities by the use of income from investments.
On several occasions when the taxpayer sought to meet or intensify competition in the marketplace for motor vehicle insurance, it budgeted for small underwriting losses. That was an option available to the taxpayer but it was not a reflection of regular policy.
The nature of the insurance business in which the taxpayer was involved was principally `short-tail' insurance, with the exception of insurance of loss occasioned by personal injuries arising out of the use of a motor vehicle. In respect of the latter insurance, the taxpayer was a member of a pool of such insurers operating as the Motor Vehicle Insurance Trust until 30 June 1981. At that time the taxpayer withdrew from the pool and from that field of insurance. The taxpayer had a potential run-off liability as a former member of the pool, but apparently that liability was not regarded as significant according to the lack of provision for it in the accounts of the taxpayer in the following years.
The premium income of the taxpayer provided a substantial cash flow which required, or permitted, a mix of investments to be undertaken. On the one hand there were investments in the short-term money market and short-term investments maturing in the course of the financial year which were reincorporated in the cash flow of the taxpayer to meet claims as they arose.
On the other hand, funds of the company which were not required to meet the estimated level of claims from year to year were invested in shares, debentures,
ATC 4739government bonds and in loans on first mortgage security. The taxpayer had no firm policy in respect of investments in shares. It was said that, in addition to assessing the potential yield, the board considered whether the investment would assist a company based in Western Australia. Usually, such a consideration would be more relevant to an allotment than a purchase in the market. Some shareholdings were obtained by allotment and others were obtained by acquisitions in the market, but almost all such investments were regarded as `blue chip'. The taxpayer, prudently, may have expected such investments to retain their value or appreciate in value and to be readily negotiable if required. In the 10 years to 30 June 1986 the taxpayer made 59 acquisitions of shareholdings in 49 companies. In that period the taxpayer made only 13 sales of shares of which nine disposals resulted from takeover offers accepted by the taxpayer.
The government bonds and semi-government securities and debentures were chosen as investments for terms of three to five years, but not more than five years. It was the pattern of the taxpayer's business to hold those investments until maturity and often to reinvest the maturing investments depending upon the yield on offer.
Moneys lent on the security of mortgages against real estate were also short-term in length, rarely more than three years and lent at fixed rates of interest.
For the purpose of its business, the taxpayer invested funds in a variety of investments that provided either an adequate yield or, alternatively, yield and opportunity for appreciation. The investments were negotiable, were medium to short-term in length and all such investments were prudent and not speculative. The taxpayer had no policy that any fixed proportions be invested in particular divisions of investment.
In carrying on its business as an insurer, the taxpayer was subject to the provisions of the Insurance Act 1973. Pursuant to that Act and the regulations thereunder, the taxpayer was required to maintain a solvency margin. In calculating the solvency margin all reserves of the taxpayer represented by the various investments were taken into account including the value of loans to its subsidiary company.
In the relevant years of income the mix of investments of the taxpayer and utilisation of the funds generated by the premium inflow reflected an intention that such investments as were not in short-term deposits would be in negotiable securities and where the investments were in bonds, debentures or mortgages, the term for maturity or repayment would be usually not more than three years and certainly no more than five. Such assets were regarded for accounting purposes as non-current assets, but with the exception of moneys advanced on mortgage security, the investments were readily realisable in markets trading in those securities. The taxpayer did not trade in those securities in the sense of buying and reselling as soon as appropriate gains could be realised. The shareholdings purchased by the taxpayer were held for their yield and their solidity and were sold only when the successful takeover bids made it necessary. At the time of the purchase, all shareholdings were `blue chip' investments in nature and not speculative and were readily negotiable if required to be converted for the purposes of the business. The shareholdings were not purchased with the intent of providing income from the trading of them. They were purchased to represent a safe holding for part of the reserves of the taxpayer's business. Similarly, in the main, securities in the form of bonds and debentures were held until maturity.
In the operation of the taxpayer's business in the relevant years of income, there was no determination by the taxpayer that its business had accumulated greater reserves than any foreseeable needs and purposes of the business may have required. The taxpayer was expected to maximise the gains of its business to allow either cheaper insurance to be offered to members of the club or distributions to the club of moneys accumulated by the taxpayer which were excess to the requirements of its business.
ATC 4740Therefore, until some other determination was made, the level of funds retained by the taxpayer and not distributed to the club was an assessment by the taxpayer of what funds the taxpayer should retain for the purpose of the conduct of its business. The taxpayer took no step to identify any part of its reserve funds as being excess to the requirements of the insurance business, nor did it apply it, or earmark it for application, to the acquisition of some new profit-earning activity or structure to expand the nature and content of its business (see
The National Bank of Australasia Limited v. F.C. of T. 69 ATC 4042; (1969) 118 C.L.R. 529;
Commercial and General Acceptance Limited v. F.C. of T. 77 ATC 4375; (1977) 137 C.L.R. 373). Nor did the taxpayer quarantine any excess funds by investing them in a distinctive manner that showed such funds had been excised from the normal run of investments maintained for the purposes of the business. (See
Chamber of Manufactures Insurance Limited v. F.C. of T. at ATC pp. 4318-4319; C.L.R. p. 604.)''
His Honour concluded (at p. 4790):
``The promotion of the investment business of the investment company and the run-down of income-earning activities of the taxpayer's business may have signalled a change in policy being effected by June of 1986, but the realisation of investments in the relevant years of income continued to be acts done by the taxpayer in furtherance of its business of insurance and the conclusion is inescapable that the gains received on such realisations were part of the profits or gains of that business.
It was not the mingling of the realised worth of investments with the income flow that gave any gain resulting from such a realisation the character of income. It was the retention of the investments for the purposes of the business that gave that character to such a gain.''
The principle to be applied was stated by the Lord Justice Clerk, the Right Honourable J.H.A. McDonald in
Californian Copper Syndicate v. Harris (1904) 5 T.C. 159 at pp. 165-166, as follows:
``It is quite a well settled principle in dealing with questions of assessment of Income Tax, that where the owner of an ordinary investment chooses to realise it, and obtains a greater price for it than he originally acquired it at, the enhanced price is not profit in the sense of Schedule D of the Income Tax Act of 1842 assessable to Income Tax. But it is equally well established that enhanced values obtained from realisation or conversion of securities may be so assessable, where what is done is not merely a realisation or change of investment, but an act done in what is truly the carrying on, or carrying out, of a business.
Is the sum of gain that has been made a mere enhancement of value by realising a security, or is it a gain made in an operation of business in carrying out a scheme for profit-making?''
F.C. of T. v. Whitfords Beach Pty. Ltd. 82 ATC 4031 at p. 4035; (1981-1982) 150 C.L.R. 355 at p. 363. Gibbs C.J., after referring to remarks in
Ruhamah Property Co. Ltd. v. F.C. of T. (1928) 41 C.L.R. 148, said:
``The judgment goes on (at p. 152) to refer to `the question whether the sale was an operation of business in carrying out a scheme of profit-making' - words of course taken from the judgment in Californian Copper Syndicate v. Harris - and it is apparent that their Honours did not intend to depart from the law as declared in that and other authorities, under which profits from carrying on or carrying out a scheme of profit-making were treated as income only if the scheme could be described as a business, a trading adventure, or a commercial venture.''
At ATC p. 4040; C.L.R. p. 372, Mason J. said:
``It has been a long-settled principle of revenue law that, unless a sale of property is made in an operation of business, the resulting profit will not be income according to the ordinary concepts and usages of mankind.''
London Australia Investment Co. Ltd. v. F.C. of T. 77 ATC 4398; (1977) 138 C.L.R. 106, per Gibbs J. at ATC p. 4403; C.L.R. p. 116 and per Jacobs J. at ATC p. 4410; C.L.R. p. 128 and
F.C. of T. v. Myer Emporium Ltd. 87 ATC 4363 at pp. 4366-4367; (1987) 163 C.L.R. 199 at pp. 209-210, in which Mason
ATC 4741A.C.J., Wilson, Brennan, Deane and Dawson JJ. commented:
``Although it is well settled that a profit or gain made in the ordinary course of carrying on a business constitutes income, it does not follow that a profit or gain made in a transaction entered into otherwise than in the ordinary course of carrying on the taxpayer's business is not income. Because a business is carried on with a view to profit, a gain made in the ordinary course of carrying on the business is invested with the profit-making purpose, thereby stamping the profit with the character of income. But a gain made otherwise than in the ordinary course of carrying on the business which nevertheless arises from a transaction entered into by the taxpayer with the intention or purpose of making a profit or gain may well constitute income. Whether it does depends very much on the circumstances of the case... The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit-making by the means giving rise to the profit.''
At ATC p. 4368-4369; C.L.R. p. 213, their Honours said:
``... over the years this Court, as well as the Privy Council, has accepted that profits derived in a business operation or commercial transaction carrying out any profit-making scheme are income, whereas the proceeds of a mere realization or change of investment or from an enhancement of capital are not income: Ruhamah Property Co. Ltd. v. F.C. of T. (1928) 41 C.L.R. 148 at pp. 151-152, 154;
McClelland v. F.C. of T. 70 ATC 4115 at pp. 4120-4121; (1970) 120 C.L.R. 487 at pp. 495-496; London Australia Investment Co. Ltd. v. F.C. of T. 77 ATC 4398 at pp. 4402-4403; (1977) 138 C.L.R. 106 at pp. 115-116; and see Whitfords Beach.
The proposition that a mere realization or change of investment is not income requires some elaboration. First, the emphasis is on the adjective `mere' (Whitfords Beach, at ATC pp. 4046-4047; C.L.R. p. 383). Secondly, profits made on a realization or change of investments may constitute income if the investments were initially acquired as part of a business with the intention or purpose that they be realized subsequently in order to capture the profit arising from their expected increase in value - see the discussion by Gibbs J. in London Australia, at ATC pp. 4403-4404; C.L.R. pp. 116-118. It is one thing if the decision to sell an asset is taken after its acquisition, there having been no intention or purpose at the time of acquisition of acquiring for the purpose of profit-making by sale. Then, if the asset be not a revenue asset on other grounds, the profit made is capital because it proceeds from a mere realization. But it is quite another thing if the decision to sell is taken by way of implementation of an intention or purpose, existing at the time of acquisition, of profit-making by sale, at least in the context of carrying on a business or carrying out a business operation or commercial transaction.''
These principles were recently applied by Davies, Pincus and Gummow JJ. in
F.C. of T. v. Equitable Life and General Insurance Co. Ltd. 90 ATC 4438, by Lockhart, Jenkinson and Gummow JJ. in
CMI Services Pty. Ltd. v. F.C. of T. 90 ATC 4428 and by Lockhart, Gummow and Hill JJ. in
F.C. of T. v. Cooling 90 ATC 4472.
It follows that profits derived from the sale of investments are ordinarily brought to account in the assessment of the income of a banking or an insurance company. As Jacobs J. said in London Australia Investment Co. Ltd. v. F.C. of T. at ATC pp. 4410-4411; C.L.R. pp. 129-130:
``A circumstances which appears to me to be of substantial significance is that referred to by Kitto J. in National Bank of Australasia Ltd. v. F.C. of T. 69 ATC 4042 at p. 4047; (1969) 118 C.L.R. 529 at p. 537:
- `... what was recovered through the sale of the shares was circulating capital, and what ultimately was not recovered was a loss on revenue account just as any excess would have been an income profit: cf.
Punjab Co-operative Bank Ltd., Amritsar v. Income Tax Commissioner, Lahore, (1940) A.C. 1055 at p. 1072;
Colonial Mutual Life Assurance Society Ltd. v. F.C. of T. (1946) 73 C.L.R. 604 at pp. 608, 614;
Australasian Catholic Assurance Co. Ltd.
ATC 4742v. F.C. of T. (1959) 100 C.L.R. 502;
C. of T. v. Commercial Banking Co. of Sydney (1927) 27 S.R. (N.S.W.) 231.'
The cases referred to are some of what may be described as the `banking' and `insurance' cases, upon which naturally the Commissioner relies quite strongly on this appeal. But there is a significant difference between a banking or insurance business which involves investment activity and the course of investment activity in the instance case. The nature of a banking or insurance business, as part of its putting of money as circulating capital to use, involves not only occasional acquisition of property in satisfaction of advances, as in the situation to which Kitto J. was referring, but also and more commonly the purchase and sale of various kinds of property whereby moneys which are obtained as part of the business but which form no part of the original capital structure of the bank or insurance company, or of that structure enhanced by accumulated net profits, are put to use short term or long term. All profits arising from that activity are profits of the business of banking or insurance. At any time and from time to time the property acquired may need to be sold, in whole or in part, to meet the requirements of the banking or insurance business and the hope and expectation is that in the meantime not only will the property have earned income but that it will have risen in value. The scale of activity coupled with the source of the funds leads to the inference that a purpose or intention of the acquisition is eventual resale at a profit. But in so far as the original capital or that capital enhanced by accumulated profits is laid out in investments in property and not in the business activity of banking or insurance, the investments will have the character of capital and profits or losses on a sale thereof will not be profits of the business of banking or insurance.''
The trial Judge was correct therefore in concluding that the investment profits of R.A.C. Insurance formed part of its assessable income. As the trial Judge pointed out, although the subject shares were not of a speculative nature and were held for the long term, nevertheless, the investment in shares was simply an overall part of the investment of the insurance reserve, much of which was invested in medium- or even short-term securities. All the investments were acquired in the course of carrying on the insurance business and all investments were available for realisation as and when required. While held, the shares produced dividend income. When sold, the profits made or losses incurred added to or reduced the profits of the insurance business. In brief, the investment of the reserve was an ordinary part of the insurance business.
Counsel for R.A.C. Insurance submitted that the principle of the insurance cases applies only to long-term insurance and not to the type of short-term insurance which R.A.C. Insurance carried on. But this is not so, as was held in Chamber of Manufactures Insurance Ltd. v. F.C. of T. 84 ATC 4315; 1984) 2 F.C.R. 455.
As with companies carrying on a business of life assurance, R.A.C. Insurance received premiums in advance of the insured event occurring. As part of its business, it invested those funds with the intent of gaining a return thereon. Such a return, whether interest, dividend or profit on sale, formed a part of the profits of the insurance business and arose from the investment of its circulating capital, the premiums received, which were reflected in the insurance reserve. Thus, the annual accounts of R.A.C. Insurance filed with the Insurance Commissioner included the subject profits in the item ``other income from insurance business''.
Counsel for R.A.C. Insurance placed weight upon the fact that R.A.C. Insurance budgeted in most years for its annual premium income to exceed its payments on claims. R.A.C. Insurance endeavoured to provide for the underwriting activity to be run at a break-even level or even at a small profit, so that recourse did not have to be made to income or profit from investments to counter an underwriting loss. Counsel therefore submitted that the insurance business of R.A.C. Insurance was in effect carried on on a cash basis, the premiums received being sufficient to meet the claims with the result, so they submitted, that the reserves were not held as an ordinary part or incident of the insurance business. But, whatever the aim of R.A.C. Insurance with respect to its underwriting result, the company could not carry on business as an insurer without maintaining adequate reserves. R.A.C. Insurance may, as a matter of practice, have
ATC 4743expended cash as and when it was received. Nevertheless, the reserves which it held represented in part the premiums it had received and in respect of which it still had obligations, either because the period of insurance had not expired or because there were oustanding claims. Balance sheets drawn up on a liquidation basis showed that, as at 30 June 1983, the claims outstanding would have been $5,091,572 and the unearned premiums $15,435,458. As at 30 June 1986, the outstanding claims would have been $8,648,000 and the unearned premiums $20,824,000. In the light of this, it is clear that the share portfolio of R.A.C. Insurance, which on 15 June 1983 had a book value of $3,390,853 and a market value of $4,534,201, was circulating capital in the sense described by Jacobs J. in the passage cited above from London Australia.
Counsel for R.A.C. Insurance relied upon
I.R. Commrs v. Scottish Automobile & General Insurance Co. Ltd. (1931) 16 T.C. 381. We agree with the trial Judge that the issue determined in that case was whether or not, as a matter of law, the Commissioners could have reached the conclusion that the profits on share investments did not represent assessable income. The finding in that case that the conclusion was open on the evidence before the Commissioners did not assist the trial Judge on the facts of the present case.
Counsel for R.A.C. Insurance further relied upon the principles enunciated in
Northern Assurance Co. v. Russell (1889) 2 T.C. 571 by the Lord President of the Court of Exchequer, Scotland, for the guidance of the Commissioners of Inland Revenue. Counsel relied particularly upon the third precept that, as fire insurance policies were contracts for one year only, premiums received for the year of assessment and ordinary expenses could be fairly taken as profits and gains of the company without taking into account of making any allowance for the balance of annual risks unexpired at the end of the financial year. Counsel submitted that this precept drew a clear distinction between a general insurance company and a life assurance company.
However, the important precept of the Lord President for present purposes is the fifth precept that ``Where the gain is made by the Company... by realising an investment at a larger price than was paid for it, the difference is to be reckoned among the profits and gains of the Company''. The Lord President's remarks in this respect and other authorities were considered in Colonial Mutual Life Assurance Society Ltd. v. F.C. of T. (1946) 73 C.L.R. 604. At pp. 617-618, Latham C.J., Dixon and Williams JJ. referred to the remarks of Lord Shaw in
Liverpool & London & Globe Insurance Co. v. Bennett (1913) A.C. 610 at p. 617. Their Honours went on to say:
``Lord Shaw said: `The series of propositions in Northern Assurance Co. v. Russell (1886) 2 Tax Cas. 571 and
Scottish Union and National Insurance Co. v. Smiles (1889) 2 Tax Cas. 551, which were formulated as instructions to the Commissioners, cover the present case, and have never been judicially controverted as a convenient guide' (1913) A.C., at p. 617. It also appears from the form of final assessment in Last's Case (1885) 10 App. Cas. 438 and from
Royal Insurance Co. Ltd. v. Stephen (1928) 14 Tax Cas. 22 that profits and losses made upon a realization of investments are, in accordance with the fifth proposition in
Northern Insurance Co. v. Russell (1886) 2 Tax Cas. 571, usually taken into account in assessing the profits and gains taxed under Case 1. On the other hand, in
Brice v. Northern Assurance Co. (1911) 6 Tax Cas. 327, at p. 345 (one of the three cases before Hamilton J. which led to the appeal to the House of Lords in Liverpool and London and Globe Insurance Co. v. Bennett (1913) A.C. 610), it was proved to the satisfaction of the Commissioners that it was not part of the business or trade of the company to deal in investments or to vary its investments or to make profits by so doing; that investments were not made or sold with the intention of earning profits and were rarely realized and then only for special reasons, and that any sums realized in excess of the cost of such investments were treated as and were capital and carried to Capital Investment Reserve Fund or used in writing off depreciation on other securities and were not in any way used or dealt with as profits or gains or taken into account for dividend purposes. Accordingly, the Commissioners held that a sum of £6,690, the net proceeds of sale of investments, was not profit or gain derived
ATC 4744or arising from the company's trade or business and that it was capital and not subject to be assessed to income tax. There was an appeal to Hamilton J. on this point but in view of this finding it was abandoned.''
After discussing authorities which might tend to the contrary view, their Honours also said, at p. 618:
``But the insistence by Lord Shaw upon the correctness of the whole of the series of propositions enunciated in Northern Assurance Co. v. Russell (1886) 2 Tax Cas. 571 after he had presumably read the remarks of Hamilton J. in the court below, and the criticism by the Privy Council of some dicta in
Commissioners of Inland Revenue v. Scottish Automobile & General Insurance Co. Ltd. (1931) 16 Tax Cas. 381 in Punjab Co-operative Bank Ltd., Amritsar v. Commissioner of Income-Tax, Lahore (1940) A.C. 1055, at p. 1072, coupled with the willingness of the Inspector of Taxes in Royal Insurance Co. Ltd. v. Stephen (1928) 14 Tax Cas. 22 to allow a loss on realization amounting to £754,000 as a deduction in computing its profits assessable under Case 1, tends to show that the sounder view is that profits and losses on the realization of investments of the funds of an insurance company should usually be taken into account in the determination of the profits and gains of the business.''
It will be noted that their Honours made no distinction between an insurance company and a life insurance company. Nor in his fifth precept did the Lord President in Northern Assurance Co. v. Russell.
The above was the view taken by Bowen C.J., Woodward and Northrop JJ. in the Chamber of Manufactures Insurance Ltd. v. F.C. of T., cited above. The present is not a case such as National Bank of Australasia Ltd. v. F.C. of T. 69 ATC 4042; (1969) 118 C.L.R. 529 or a case such as that referred to in Chamber of Manufactures Insurance Ltd. v. F.C. of T., where, at ATC p. 4319; F.C.R. p. 460, their Honours referred to the circumstance where funds of an insurance company may be invested in the construction of a building to be used as a head office or the insurance company might maintain two quite separate funds, the first acknowledged as the reserve fund demonstrably sufficient to meet claims and expenses in all reasonably foreseeable contingencies and the second categorised and dealt with as an investment fund. The facts of the present case are not sufficient to distinguish the circumstances from the general principle; indeed they are illustrative of it.
In our opinion, therefore, the subject profits were profits of the business of a company carrying on an insurance business and were assessable as such.
We would dismiss the appeal with costs.
THE COURT ORDERS THAT:
The appeal be dismissed with costs.