W.D. & H.O. WILLS (AUSTRALIA) PTY LTD v FC of T
Judges:Sackville J
Court:
Federal Court of Australia
Sackville J
Introduction
Background
The applicant, W.D. & H.O. Wills Australia Ltd (``Wills''), appeals against four decisions of the respondent (``the Commissioner''). The appeals have been heard together. In those decisions, the Commissioner disallowed objections lodged by Wills against amended assessments issued in respect of the financial years ended 31 October 1986, 31 October 1987, 31 October 1988 and 31 October 1989.
The amended assessments disallowed the deductions for payment of premiums claimed by Wills in respect of each of those financial
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years. The premiums were paid to Matila Insurance Pty Ltd (``Matila''), an insurer incorporated and doing business in Singapore. The deductions claimed and disallowed were as follows: Year Ended Deduction
31 October $
1986 4,200,000
1987 4,664,000
1988 167,966
1989 3,593,140
Until 2 August 1989, Wills was a wholly owned subsidiary of Amatil Ltd, now known as Coca Cola Amatil Ltd. Matila was incorporated in Singapore, on 7 October 1986, also as a wholly owned subsidiary of Amatil. Matila was described in contemporary documentation and in evidence as a ``captive insurer''. Although counsel did not agree on a definition, in general terms, this phrase embraces a wholly owned subsidiary of a parent company which provides insurance coverage only to other companies within the same group.
The amended assessments were issued to Wills as the result of an audit carried out by the Commissioner. In each case the Commissioner made a determination under s. 177F(1) of the Income Tax Assessment Act 1936 (Cth) (``ITA''), which is within Part IVA of that Act. The determinations were in substantially the same form. It is therefore sufficient to set out the determination in respect of the year ended 31 October 1986, which was made on 21 April 1993:
``IN RESPECT OF W.D. & H.O. Wills (Australia) Limited (`the taxpayer') which in the year of income ended 31 October, 1986 has obtained, or would but for the operation of section 177F obtain, a tax benefit in connection with a scheme to which Part IVA of the Act applies, namely a deduction of $4,200,000 being allowable to the taxpayer in respect of payment of that amount to Matila Insurance Pte Limited as `insurance premiums'.
THAT the whole of the amount of that deduction of $4,200,000 shall not be allowable to the taxpayer in relation to the year of income ended 31 October, 1986.''
The Issues
The Commissioner, in addition to putting Wills to proof of all facts on which it relies to establish that the assessments are excessive, contended as follows:
- (i) the premiums paid by Wills to Matila were not, within the meaning of s. 51(1) of the ITA, outgoings incurred by Wills in gaining or producing its assessable income, nor were they necessarily incurred in carrying on a business for the purpose of gaining or producing such income;
- (ii) in any event, the premiums were outgoings of capital, or of a capital nature, and were therefore not allowable deductions under s. 51(1) ITA; and
- (iii) even if the deductions claimed by Wills in respect of the insurance premiums were allowable deductions under s. 51(1) of the ITA, Wills was party to a scheme and had obtained a tax benefit in connection with the scheme; further, having regard to the eight factors set out in s. 177D(b) of the ITA, it should be concluded that the persons who entered into the scheme did so for the dominant purpose of enabling Wills a tax benefit, namely, deductions which it would not have obtained had the scheme not been entered into.
Wills argued that the premiums were allowable deductions under s. 51(1) and were not outgoings of capital, or of a capital nature. Wills also contended that Part IVA of the ITA did not apply because
- (i) it had not obtained any tax benefit in connection with any scheme; and
- (ii) having regard to the eight statutory criteria in s. 177D(b), the scheme identified by the Commissioner was not one of which it could be concluded that it was entered into for the dominant purpose of enabling Wills or any other taxpayer to obtain a tax benefit in connection with the scheme; rather the dominant purpose was to obtain insurance for what would otherwise have been an uninsurable risk.
The Scheme Identified by the Commissioner
In connection with the argument relating to Part IVA, it is convenient to set out the scheme identified by the Commissioner for the purposes of the determination made by him under s. 177F of the ITA:
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``The `scheme' referred to in the section 177F determination is:-
- (i) the plan to establish a captive insurance company at least as early as mid 1986 principally to provide `insurance' to Wills in respect of risks for which cover was not available from third party insurers at acceptable rates;
- (ii) the incorporation of Matila on 7 October 1986 and the obtaining of the necessary approvals from regulatory authorities for Matila to operate as an insurance company in Singapore;
- (iii) the entering into of the policies of insurance between Matila and Wills;
- (iv) the payments by Amatil Ltd to Matila in relation to those policies;
- (v) the operation of Matila, including the investment of funds received from Amatil Ltd; and
- (vi) the charging of Wills by Amatil Ltd for Wills' proportion of the payments made to Matila.''
As
FC of T v Peabody 94 ATC 4663; (1993-1994) 181 CLR 359 demonstrates, the erroneous identification of the scope of a scheme by the Commissioner does not necessarily mean that the discretion conferred by s. 177F(1) of the ITA has been wrongfully exercised. It may be open to the Commissioner to describe the scheme in alternative ways and to amend the description of the alleged scheme in the course of proceedings: 94 ATC 4669-4670; 181 CLR at 381-383.
In the present case, however, the Commissioner did not seek to amend the particulars of the scheme. Although there was a brief reference in the Commissioner's written submission to an alternative way of identifying the scheme, I did not understand the Commissioner to depart in substance from the scheme specified for the purposes of his determination. In other words, the case was fought on the basis that the application of Part IVA of the ITA was to be considered by reference to the scheme identified by the Commissioner.
The statutory framework
Section 51(1)
The first aspect of the case depends on s. 51(1) of the ITA, which reads as follows:
``(1) All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income.''
Part IVA
The balance of the case depends on the operation of Part IVA of the ITA. That Part was introduced into the ITA by the Income Tax Laws Amendment Act (No. 2) 1981 (Cth) and applies to any ``scheme'' entered into or carried out after 27 May 1981: s. 177D. As Hill J. observed in the Full Court in
Peabody v FC of T 93 ATC 4104 at 4110; (1993) 40 FCR 531 (FCA/FC), at 538-539, Part IVA was intended to provide a general anti-avoidance measure to replace the earlier anti-avoidance provision, s. 260, which at that time ``stood somewhat discredited''.
The Second Reading Speech, delivered by the then Treasurer, articulates the policy said to underlie Part IVA:
``The proposed provisions... seek to give effect to a policy that such measures ought to strike down blatant, artificial or contrived arrangements, but not cast unnecessary inhibitions on normal commercial transactions by which taxpayers legitimately take advantage of opportunities available for the arrangement of their affairs...
In order to confine the scope of the proposed provisions to schemes of the blatant or paper variety, the measures in this Bill are expressed so as to render ineffective a scheme whereby a tax benefit is obtained and an objective examination, having regard to the scheme itself and to its surrounding circumstances and practical results, leads to the conclusion that the scheme was entered into for the sole or dominant purpose of obtaining a tax benefit.''
Hansard, HR, 27 May 1981, 2683 (The Hon J. Howard).
The Explanatory Memorandum circulated with the Bill identified four limitations on the scope of s. 260 of the ITA, which Part IVA was
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intended to address. In summary, these limitations were:- • s. 260 was construed in accordance with the ``choice principle'', so as not to deny to taxpayers a right to choose a form of transaction to achieve a particular result if the ITA itself permitted that form of transaction;
- • s. 260 was construed as preventing inquiry into the purposes or motives of the persons entering the transaction, but as requiring the purpose of an arrangement to be tested by examining the effect of the arrangement itself;
- • it was unclear whether s. 260 permitted an arrangement to be held void in part only; and
- • s. 260 did not provide for reconstruction of the transaction in order to arrive at a taxable situation.
The relevant terms of the Explanatory Memorandum are extracted in the judgment of Hill J. in Peabody, at ATC 4110; CLR 539. For further background as to the construction of s. 260 see J. Passant, ``Tax Avoidance in Australia: Results and Prospects'' (1994) 22 Fed L Rev 493, at 494-511.
One difference between s. 260 and Part IVA is that the latter does not operate of its own force, but is dependent upon an exercise of the Commissioner's discretion to cancel a ``tax benefit'' obtained by a taxpayer in connection with a ``scheme'':
FC of T v Spotless Services Limited & Anor 95 ATC 4775 (FCA/FC) at 4792, per Beaumont J. (dissenting as to the result). The Commissioner's power is conferred by s. 177F(1):
``(1) Where a tax benefit has been obtained, or would but for this section be obtained, by a taxpayer in connection with a scheme to which this Part applies, the Commissioner may-
- (a) in the case of a tax benefit that is referable to an amount not being included in the assessable income of the taxpayer of a year of income - determine that the whole or a part of that amount shall be included in the assessable income of the taxpayer of that year of income; or
- (b) in the case of a tax benefit that is referable to a deduction or a part of a deduction being allowable to the taxpayer in relation to a year of income - determine that the whole or a part of the deduction or of the part of the deduction, as the case may be, shall not be allowable to the taxpayer in relation to that year of income;
- ...
and, where the Commissioner makes such a determination, he shall take such action as he considers necessary to give effect to that determination.''
The expression ``scheme'' is defined, by s. 177A(1) in very wide terms to mean:
``(a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and
(b) any scheme, plan, proposal, action, course of action or course of conduct;''
This definition is expanded by s. 177A(3) which expressly includes a unilateral scheme.
``(3) The reference in the definition of `scheme' in subsection (1) to a scheme, plan, proposal, action, course of action or course of conduct shall be read as including a reference to a unilateral scheme, plan, proposal, action, course of action or course of conduct, as the case may be.''
The concept of a tax benefit is defined in s. 177C(1):
``(1) Subject to this section, a reference in this Part to the obtaining by a taxpayer of a tax benefit in connection with a scheme shall be read as a reference to-
- (a) an amount not being included in the assessable income of the taxpayer of a year of income where that amount would have been included, or might reasonably be expected to have been included, in the assessable income of the taxpayer of that year of income if the scheme had not been entered into or carried out; or
- (b) a deduction being allowable to the taxpayer in relation to a year of income where the whole or a part of that deduction would not have been allowable, or might reasonably be expected not to have been allowable, to the taxpayer in relation to that year of income if the scheme had not been entered into or carried out;
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- ...
and, for the purposes of this Part, the amount of the tax benefit shall be taken to be:-
- (c) in a case to which paragraph (a) applies - the amount referred to in that paragraph; and
- (d) in a case to which paragraph (b) applies - the amount of the whole of the deduction or of the part of the deduction, as the case may be, referred to in that paragraph.''
Section 177D specifies the schemes to which Part IVA applies. That section provides that where:
``(a) a taxpayer (in this section referred to as the `relevant taxpayer' ) has obtained, or would but for section 177F obtain, a tax benefit in connection with the scheme; and
(b) having regard to:-
- (i) the manner in which the scheme was entered into or carried out;
- (ii) the form and substance of the scheme;
- (iii) the time at which the scheme was entered into and the length of the period during which the scheme was carried out;
- (iv) the result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme;
- (v) any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme;
- (vi) any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme;
- (vii) any other consequence for the relevant taxpayer, or for any person referred to in subparagraph (vi), of the scheme having been entered into or carried out; and
- (viii) the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in subparagraph (vi),
it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for the purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme or of enabling the relevant taxpayer and another taxpayer or other taxpayers each to obtain a tax benefit in connection the scheme...''
The reference to purpose in s. 177D is elucidated by s. 177A(5):
``(5) A reference in this Part to a scheme or a part of a scheme being entered into or carried out by a person for a particular purpose shall be read as including a reference to the scheme or the part of the scheme being entered into or carried out by the person for 2 or more purposes of which that particular purpose is the dominant purpose.''
Subject to an irrelevant exception, nothing in the ITA is to be taken as limiting the operation of Part IVA: s. 177B(1).
The Nature of the Evidence
Mr Ellicott QC, who appeared with Mr Edmunds SC for Wills, read a number of affidavits. The deponents were
- • Mr Watson, the Risk and Insurance Manager for Amatil at the relevant times;
- • Mr Priest, formerly the Finance Director of Amatil, to whom Mr Watson reported;
- • Mr Michie, whose title was Manager, Risk and Insurance of Amatil and who reported to Mr Watson;
- • Mr O'Shea, formerly the Australian Liability Underwriter for QBE Insurance Ltd (``QBE'') which, until 1987, provided products liability cover for Wills;
- • Mr Tyler, who at the relevant times, was a director of Sedgwick International Ltd, the UK parent of Sedgwick Ltd which, from 1986, acted as insurance broker to Amatil; and
- • Mr Marshall, an insurance underwriter experienced in the UK reinsurance market, who gave brief expert evidence.
The affidavits of the first five deponents annexed documentation relating to dealings or transactions involving Amatil, Wills and Matila. Additional documents were tendered in the course of the hearing.
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The Commissioner was represented by Mr Shaw QC, who appeared with Mr Pagone. Either Mr Shaw or Mr Pagone cross-examined each of the deponents to whom I have referred (Messrs Watson, Tyler and Marshall giving evidence by means of video link). It is important to note that no attack was made on the credit of any of the witnesses, and it was not suggested by Mr Shaw that I should reject any part of their evidence. I record that I formed the view that each of the witnesses attempted to give his evidence truthfully. In particular, I formed the view that Messrs Watson, Priest and Michie, who were officers of Amatil at the relevant times, gave accurate accounts of the events leading up to and subsequent to the formation of Matila. Of course, because of the passage of time, they did not necessarily recall all events with precision, but this in my view did not impair the general reliability of their evidence.
The following account of events is based primarily on the documentary evidence supplemented where necessary by the affidavit and oral evidence. In substance there was no dispute as to the relevant events, although the parties were at issue concerning the appropriate inferences to be drawn from these events.
The course of events
As I have said, at all relevant times until 2 August 1989, Wills was a wholly owned subsidiary of Amatil Ltd (``Amatil''), a listed Australian public company. Amatil was described in evidence as an Australian diversified conglomerate. It conducted a variety of business through its subsidiaries, including printing and packaging, snack foods, poultry, beverages and tobacco. The various business groupings were frequently referred to in reports and other communications as business divisions of Amatil. Wills itself carried on the business of manufacturing and marketing tobacco products for human consumption.
Amatil's Products Liability Cover
Prior to October 1983 the Amatil Group was insured against liability to third parties under a General and Products Liability Policy, issued by QBE. The policy had been arranged through Amatil's Risk and Insurance Department, headed by Mr Watson, which at the time managed insurance for all companies within the Amatil Group. The department was responsible for identifying risks and placing insurance for the Group companies. When insurance was placed and the premiums paid to underwriters, the department allocated the premiums to companies within the Group in accordance with an assessment of their contributions to the risk.
The policy issued by QBE contained an exclusion clause, providing that the insurer would not be liable with respect to liability consequent on or traceable to cancer arising from the consumption of cigarettes or tobacco products sold or supplied by Amatil and its subsidiaries. This clause was referred to in evidence as ``the cancer exclusion''.
In about September or early October 1983 Mr O'Shea, of QBE, advised Mr Michie of Amatil's Risk and Insurance Department, that QBE proposed to extend the cancer exclusion to cover other diseases said to be attributable to the consumption of tobacco. On 18 October 1983, Mr O'Shea wrote to Mr Michie outlining QBE's terms for renewal of the policy. The policy limit was to be $5 million and the cancer exclusion was to be replaced by the following exclusion:
``TOBACCO
Based upon or alleging the contraction, aggravation or exacerbation of carcinoma, arteriosclerosis, heart disease or other disease of the human body as a result of consumption or use of tobacco products sold, handled or distributed by the Insured.''
Following this advice, Mr Watson sought the views of Amatil's then insurance brokers, Reid Stenhouse (NSW) Ltd. Mr Watson also sought information from BAT Industries plc (``BAT''), a UK company associated with Amatil, concerning the experience with product liability insurance of members of the BAT Group. BAT replied that there were no specific exclusions of the health hazard in most other countries. Thus the risk was covered by underwriters, ``albeit perhaps unknowingly''. The position in the United States and Canada was different, in that only limited coverage of health risks was provided.
On 16 February 1984, the Liability Manager of Reid Stenhouse advised Mr Michie, by letter, to resist QBE's attempt to broaden the cancer exclusion and, should QBE insist, to seek quotations from other insurers for a policy not subject to a broad health exclusion.
On 1 March 1984, Mr Michie wrote to QBE seeking terms for the deletion of the cancer
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exclusion. The letter pointed out that at least one of Wills' major competitors in Australia had no exclusion whatsoever for cancer or indeed any other disease. The letter also noted that cover was available in other countries without the cancer exclusion.Following this letter, discussions took place between Mr Watson and Mr O'Shea. The upshot, as recorded in a letter of 6 June 1984 from Mr Watson to Reid Stenhouse, was that QBE agreed to delete the cancer exclusion, subject to a separate additional premium of $20,000, to be reviewed annually. QBE's change of heart was prompted by the fact that Mr O'Shea found that he could arrange reinsurance of the risk through a London broker. Wills was to consider whether it would take up QBE's proposal before approaching the excess layer underwriters.
Mr Watson prepared a report to Wills' Managing Director on 5 July 1984. The report recounted developments relating to the Group's products liability insurance policies. Mr Watson observed that the insurance had been placed in a number of layers, providing coverage of $100 million in respect of all claims during any one year. He recommended that there was merit in taking out the additional coverage offered by QBE, although he acknowledged that any insurance protection would be likely to survive only until such time as a successful claim was brought in Australia. Mr Watson suggested that, if this cover were arranged, he should commence negotiations with the insurers underwriting the upper layers of liability cover to obtain a similar extension.
On 17 August 1984 Mr Michie advised QBE that he had received instructions from Wills to take up the quotation to delete the cancer exclusion, with effect from renewal on 31 October 1984, subject to agreement being reached on the control of defence of such claims. Mr Michie foreshadowed his intention of writing to the excess underwriters to obtain their agreement to deletion of the cancer exclusion, at premiums to be agreed.
A file note of September 1984 by Mr Michie states that he had been told by Mr O'Shea that QBE was having some difficulty obtaining re- insurance for the cancer cover under the primary policy. Another file note by Mr Michie, dated 10 September 1984, records Mr O'Shea's advice that a number of underwriters had indicated that they would be unable to continue with the cancer coverage.
On 30 October 1984, QBE acknowledged receipt of closing instructions for public/ products liability on behalf of Amatil ``and others as per Schedule attached'', in respect of the period 31 October 1984 to 31 October 1985. QBE was the underwriter for the primary policy, which was subject to a limit of $5 million in respect of any one occurrence or series of occurrences arising out of a single event. Excess layers increased the coverage for 1984-1985 to $25 million.
From early November 1984 to January 1985, various communications passed between Amatil and insurers concerning the difficulty of placing layers of excess insurance due to the inclusion of the cancer coverage. In November 1984 American Home Assurance Company (``American''), which was the underwriter for the second excess layer of $15 million, advised Mr Michie that the coverage provided under its policy was cancelled. However, in January 1985, American withdrew the notice of cancellation on the ground that reinsurance of the cancer coverage had been completed.
The First Proposal for a Captive Insurer
The first mention of a proposal for a captive insurance company is in an internal document, dated 28 November 1984, prepared by Mr Watson, entitled ``Captive Insurance Company - Justification''. This document included the following passages:
``Amatil's insurance programme has developed to the stage where the types of insurance now required are more readily available from the reinsurance (wholesale) market rather than from the conventional insurance (retail) market. Amatil cannot gain direct access to and control placements in the reinsurance market other than through its own (captive) insurance company.
The high insurance limits required by Amatil (currently combined property/ business interruption limit of $500 million) means that a high proportion of its premiums are already channelled to the overseas reinsurance market by our existing insurers.
The insurers currently used by Amatil consist of the larger established insurance companies operating in Australia which are, in the main, overseas controlled.
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...
Amatil is, therefore, considering the formation of a captive insurance company in order to enable it to control and more effectively place such reinsurances.
An offshore Company is preferred by Amatil because it is less expensive to establish and operate. The location currently preferred is Hong Kong.''
Mr Watson initiated discussions with the Australian Taxation Office (``ATO'') concerning the proposal. He subsequently formally applied on behalf of Amatil for a tax clearance certificate, under s. 14C of the Taxation Administration Act 1953 (Cth), for a clearance to invest the sum required to provide the capital for the proposed Hong Kong captive. In response to a request from the ATO for further information, Mr Watson stated the following:
``The need to reorganise our material damage/consequential loss insurance arrangements is the motivating factor in us undertaking this exercise but any class of insurance could be a potential subject for insurance through the captive insurance company, if established.''
In the result, Amatil did not proceed with the proposal for a captive insurance company in Hong Kong, because the conditions imposed by the ATO for a tax clearance certificate were not acceptable to Amatil. In particular, Amatil did not regard as acceptable the ATO's requirements as to management and control of the captive.
A Hardening Insurance Market
On 11 October 1985, QBE put its proposal to Amatil for renewal of the primary products liability insurance policy. Among other things, QBE required the policy wording to be amended to exclude health risks, the exclusion being in the same terms as that originally proposed in October 1983. Mr O'Shea had previously told Mr Michie that QBE's attitude had changed because QBE had experienced difficulty in obtaining reinsurance for the health risk for the 1985/1986 year. QBE's letter of 11 October 1985 noted that it was still attempting to include the cancer exposure, but that it was ``experiencing difficulties in this regard''.
Mr O'Shea gave evidence (which I accept) that it was his considered opinion at the time that the risk was virtually unwritable. If the risk were to be underwritten, he said that he would have wanted ``a lot of money for it'', which he suggested meant a premium ``in the hundreds of thousands of dollars''.
On 21 October 1985, Mr Watson sent a memorandum to Mr Priest, the Finance Director of Amatil, with copies to all Amatil directors. The memorandum noted that the overseas reinsurance ``capacity crunch'' was beginning to be reflected in the property and liability classes of insurance in Australia. It stated that, after consultation with Amatil's brokers, Reid Stenhouse, Amatil had attempted to exploit its goodwill with underwriters, by obtaining the best renewal terms possible with local underwriters, rather than embarking on an extensive remarketing exercise.
The memorandum recounted the renewal action in relation to various classes of insurance. Under the heading ``Public/Products Liability'' the memorandum said the following:
``The combined limit for this class was increased to $100 million in 1983/84. Cover is placed in a series of layers with the Primary layer of $5 million being underwritten by Kemper in the case of Steggles and QBE for all other Group companies. The other layers cover all Group Companies.
Claims have averaged $80,000 per annum over the past 5 years but with this class it is the potential exposure more than past experience which influences premium rates.
As mentioned in the preamble to this report, liability insurance is the class most affected by the current hardening of the reinsurance market, particularly in U.S.A....
We have also been unable to renew the cover against health risks consequent upon consumption of tobacco products. Last year we were able to obtain cover of $25 million at a premium of $40,000. This year cover is extremely difficult to obtain and indications are that were it available the cost could be as high as $300,000.''
Mr Watson concluded that the hardening of the insurance market added support to the Group's ``established philosophy of self-insuring regular and predictable losses and limiting reliance on insurance to catastrophic type losses''.
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Sedgwick's Inquiries
In February 1986 Mr Watson invited submissions from three insurance brokers to provide consultancy services on the expiry, in April 1988, of the existing arrangements. The invitation did not suggest that Amatil was considering establishing a captive insurer. On 1 May 1986 Amatil accepted Sedgwick's proposal for a consultancy, using a team headed by Mr Moule.
On 4 July 1986 Mr Moule wrote to Mr Michie expressing the view that Amatil should consider purchasing insurance for a number of risks presently uninsured. In particular, he expressed concern about the health risk exclusion in the Products Liability policy, as well as risks associated with bad debts and products recall.
Shortly thereafter, Mr Moule communicated by telex with Mr Tyler, then a director of Sedgwick International Ltd, based in London. Mr Tyler had responsibility for the Sedgwick Group's international liability portfolio, outside the United Kingdom, excluding the United States. The telex read as follows:
``AMATIL IS AN ASSOCIATE OF BAT INDUSTRIES AND HAS A SUBSTANTIAL BUSINESS IN AUSTRALIA IN CIGARETTE AND OTHER TOBACCO PRODUCTS. THEY ARE ALSO PRINTERS, POULTRY GROWERS AND DISTRIBUTORS, SOFT DRINK MANUFACTURERS, AND MANUFACTURERS ETC OF SNACK FOODS.
WE HAVE IDENTIFIED A NUMBER OF OMISSIONS FROM THEIR EXISTING INSURANCE PROGRAMME WHICH IS PLACED ALMOST 100 PCT IN AUSTRALIA AND THESE ARE HEALTH RISK LIABILITY ARISING FROM TOBACCO PRODUCTS AND PRODUCTS RECALL GENERALLY.
AS I HAVE SAID, THE TOBACCO BUSINESS IS SUBSTANTIAL WITH A TURNOVER OF ADLRS 1,000 MILLION PER ANNUM APPROXIMATELY AND THE PRESENT PRODUCTS LIABILITY COVER EXCLUDES CLAIMS FOR PERSONAL INJURY ARISING THROUGH CANCER AND HEART DISEASE BROUGHT ABOUT BY SMOKING.
DO YOU THINK YOU COULD PLACE A PRODUCTS LIABILITY COVER FOR THESE RISKS AND DO YOU HAVE ANY FEELING FOR THE PREMIUM COST?
PRODUCTS RECALL IS LIKEWISE UNINSURED EXCEPT FOR A PRODUCTS PROTECTION POLICY WITH CHUBB WHICH COVERS THE COST OF RECALL WHERE THERE HAS BEEN A CRIMINAL ADULTERATION.
IS IT POSSIBLE TO COVER RECALL RISK FOR AMATIL AND WHAT MIGHT THE COST BE? THE TOTAL TURNOVER FOR ALL AMATIL PRODUCTS IS ABOUT ADLRS 2,000 MILLION.''
Mr Tyler's reply was not promising:
``THE INABILITY OF SUCH COMPANIES TO OBTAIN HEALTH COVER FOR THEIR PRODUCTS RISK IS NOT NEW. OUR EXPERIENCE OF LATE IS THAT WHILST IT MIGHT BE POSSIBLE TO OBTAIN TERMS FROM ONE OR TWO UNDERWRITERS, THE POTENTIAL TO COMPLETE 100 PCT OF THE RISK IS SIMPLY NOT THERE. IN SOME CASES INVOLVING OTHER TOBACCO COMPANIES THERE IS HEALTH RISKS COVER BUT THIS HAS BEEN INSURED FOR MANY YEARS AND UNDERWRITERS HAVE CONTINUED WITH THE INSURANCE ALTHOUGH THE INDEMNITY LIMITS HAVE BEEN SUBSTANTIALLY REDUCED.
THE PREMIUM COST FOR HEALTH RISKS WOULD BE EXTREMELY HIGH ASSUMING WE WERE ABLE TO GET THE COVER AND IT WOULD BE NECESSARY FOR A `CLAIMS MADE' FORM TO BE USED BECAUSE OF THE DURATION OVER WHICH HEALTH IS AFFECTED BY SMOKING.
A VERY HIGH PREMIUM ON LINE WOULD BE REQUIRED AND CONVERTING THAT TO A RATE ON TURNOVER FOR COVER OF, SAY, DLRS 10 MILLION, YOU WOULD NEED TO BE THINKING OF ABOUT PT 5 PCT GROSS.
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PRODUCTS RECALL IS NOT QUITE AS DIFFICULT BUT I SUGGEST THE TWO COVERS SHOULD BE TIED TOGETHER FOR THE SAKE OF GOOD ORDER. I AM SORRY TO BE SO NEGATIVE BUT THE MARKET IS ALMOST TOTALLY IMPOSSIBLE FOR THIS CLASS OF PRODUCTS LIABILITY RISK.''
I should interpose that Mr Tyler explained in his evidence that the sum of A$10 million had been chosen because that was
``the largest limit that one would have expected to place... That was the standard for a normal type of risk.''
Mr Tyler said that insurance of this magnitude could have been underwritten only if the underwriters were able to reinsure most of their risk. Having regard to the known health hazards of smoking, his view at the time was that even an underwriter prepared ``to have a punt'' would have only accepted a very small proportion of A$10 million. Accordingly, he did not consider it feasible to achieve anything like A$10 million coverage. Indeed, he expressed the opinion that for a new client coming into the market as was Amatil (as distinct from a client wishing to continue historical coverage), coverage was impossible.
Mr Tyler selected the premium of 0.5 percent of turnover because he considered that an underwriter willing to accept the risk, albeit for a small fraction of A$10 million, would ``look at it as a two to one shot''. Since Mr Tyler understood that Wills' tobacco business had a turnover of A$1,000 million, he selected a premium rate of 0.5% of turnover to achieve a two to one balance - that is a premium of A$5 million in respect of a risk of A$10 million. Mr Tyler was asked in cross-examination about the odds of two to one:
``A 2 to 1 odds, as it were, are pretty good, are they not? - Good for whom?
A fair question, are good for the insurance company? - I certainly wouldn't take them myself if I was an underwriter. Apart from the full knowledge of the risk, there is another theory which I believe the Americans know as the deep pocket theory, that if it is known that a tobacco manufacturer, or distributor, or anybody with such a high risk has any form of insurance cover that I think people who had suffered from cancer would be encouraged by the legal fraternity to sue them...''
The Second Proposal for a Captive Insurer
In August 1986 Mr Moule prepared a report to Amatil entitled ``Captive Insurance''. The report set out the objectives and advantages of establishing a captive instead of an internal fund or external insurance, while pointing to ``minor disadvantages''.
``The hardened and inflexible attitude of insurance underwriters invites companies to look for alternative ways of insuring their risk exposures. Insurance by AMATIL Limited with a wholly owned subsidiary insurance company, a captive, is feasible for some classes of risk and is in accordance with a trend adopted by many large companies around the world. It will, in particular, help AMATIL protect the health risk in connection with Products Liability for which conventional insurance cannot be obtained.
1. OBJECTIVES
The objectives of AMATIL in insuring with a captive will include:-
- 1.1 To self insure risks presently uninsured.
- 1.2 To reduce AMATIL'S dependence upon the external commercial insurance market for their present insurances.
- 1.3 To reduce the cost of risk to AMATIL. (The cost of risk being the sum of insurance premiums, retained losses and risk control and management costs).
2. ADVANTAGES OF SELF INSURANCE USING A CAPTIVE INSTEAD OF AN INTERNAL FUND OR EXTERNAL INSURANCE
- 2.1 A captive will formalise the funding aspect of risk management.
- 2.2 Internally, AMATIL employees will know that losses are being retained in the Group and therefore have greater interest in risk control.
- 2.3 Reserves of the captive will be built up from retained earnings to permit growth in captive insurance and a reduction in external insurance.
- 2.4 A captive will be able to deal at arms-length with the public on claims
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whereas an internal fund would mean face-to-face dealing and increased difficulty with public relations.- 2.5 Investment earnings on premiums and reserves will be retained within AMATIL Group rather than with insurers as is the case with present external insurances.
- 2.6 A captive will permit direct access to the wholesale reinsurance market.
There are, however, some minor disadvantages in having a captive, firstly it must be capitalized and remain solvent..., secondly it will require some additional management time by AMATIL although this is offset by the use of a management company and thirdly, it can incur an underwriting loss in any one year.
The latter point of the potential for a loss is important and is the reason why the captive must be properly founded [query: funded?] , prudently managed and look for a steady growth to build up reserves.''
Section 3 of the report made suggestions for the initial portfolio of the captive, with the policies to be issued on a ``claims made'' basis:
``Section 1 - Products Liability and Recall
In respect of-
- a) Health Risks
- The indemnity provided by this section shall apply to liability and legal costs based upon or alleging the contraction, aggravation or exacerbation of carcinoma, arteriosclerosis, heart disease or other disease of the human body as a result of consumption or use of tobacco products sold, handled or distributed by the Insured anywhere in the world.
- b) Recall
- ...
Deductible: A$10,000 any one claim Limit: $10,000,000 in respect of any one period of insurance.Section 2 - Bad Debts
In respect of loss of income due to bad debts anywhere in the world.
Deductible: A$3,250,000 annual aggregate Limit: A$2,000,000 in respect of any one period of insurance.Policy Limit
In respect of any one period of insurance, the limit of insurers liability will not exceed $A10,000,000 under all sections combined.
Premium
A minimum and deposit premium for the first insurance period to 30th September, 1987 of A$5,000,000 plus local stamp duty will be appropriate.
This premium to be adjusted on expiry on the following basis:-
Section 1a .400% on tobacco turnover. 1b .025% on total turnover. Section 2 .025% on total turnover.During the course of the next twelve months other classes of insurance will be investigated for inclusion in the captive portfolio.''
The report briefly reviewed Amatil's loss history, noting, among other things, that there had been no losses to date in respect of health risks liability arising from tobacco products and that any reported incidents had been successfully defended. It also canvassed a number of possible ``domiciles'' for the captive. It proposed that Singapore be selected, since it offered:
- ``• Good communication with Australia and is in a close time zone.
- • An infrastructure of financial, accounting and legal services of a high order.
- • Firms for providing these services related to AMATIL's current consultants in Australia, particularly, Sedgwick and Deloitte Haskins and Sells.
- • Reasonable levels of cost.
- • Concessional rates of tax but is not regarded as a tax-haven by Australian authorities.
- • Freedom from exchange control.
- • The potential for investments to be made by the captive with the Parent Group at commercial rates of interest.''
Mr Moule suggested that the shares in the Singapore captive should be vested in Amatil.
The report addressed other issues, including capital/solvency requirements, management and administration and financial matters. It noted that a Singapore captive insurance company had
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to be placed in the hands of a licensed management company and proposed that the Sedgwick Group provide these services. The report attached what was described as a ``projected profit and loss statement for the first three years''. This was based on a gross premium of $5 million per annum, a single claim of $3 million in the second year, funds invested at 15% per annum in Australia and no payment of dividends during the first three years. The projection also assumed a provision of 25% of premiums each year for what are described as IBNR's (claims incurred but not yet reported). On these assumptions, the proposed captive showed profits of about $2 million in the first year, $3 million in the second and $6 million in the third.Under the heading ``Start Up'' the report concludes as follows:
``It is important that the captive be in place during the financial year to 31 October 1986 to permit a build up of reserves therefore early authority for formation is sought.''
On 3 September 1986 Mr Watson forwarded the Sedgwick report to Mr Priest, with a recommendation that the captive be established. Mr Watson's memorandum contained the following passages:
``I have recently been examining, in association with our insurance consultants, Sedgwick Limited, alternative means open to the Group to protect itself against the potential legal liability of Tobacco Division for health risks associated with the consumption of tobacco products. This is a high-risk exposure for Tobacco Division as evidenced by the legal action currently being undertaken in Australia by Mrs Scanlon against the American Cigarette Company.
Sedgwick have ascertained from their London office that this insurance is not currently available from the commercial insurance market and were it to be available it would attract a premium rate of around.5% on turnover for a cover of $10 million. This translates to an annual premium of $5.5 million.
...
Recommendation
In view of the increasing pressure on the tobacco industry from various special interest groups it is likely further actions, similar to the Scanlon case, will be commenced. I believe it is essential we move as quickly as possible to establish the Captive and arrange protection against this risk. I therefore seek approval to proceed without delay to implement the recommendations contained in the Sedgwick report.''
The reference to the Scanlon case was to proceedings commenced in Victoria in August 1986, which gave rise to a series of reported decisions on interlocutory issues:
Scanlon v American Cigarette Company (Overseas) Pty Ltd (No. 1) [1987] VR 261 (SCt Vic/Nicholson J.);
Scanlon v American Cigarette Company (Overseas) (No. 2) [1987] VR 281;
Scanlon v American Cigarette Company (Overseas) (No. 3) [1987] VR 289.
On 5 September 1986 Mr Priest agreed to the proposal.
The Formation of Matila
Following Mr Priest's approval events moved quickly. On 16 September 1986 Amatil submitted an application to the Monetary Authority of Singapore (``MAS'') for approval to set up a captive insurance company in Singapore. The application attached the Sedgwick report. Eight days later, on 24 September 1986, the Board of Amatil agreed to the proposal to establish the captive in Singapore. On 3 October 1986 MAS approved the application, subject to a number of conditions. These included a requirement that the captive have a paid up capital of not less than S$1 million and that it not insure or re- insure the risks of any individual or company, other than to parent and related companies. The conditions were later accepted by Amatil.
On 7 October 1986 Matila was incorporated in Singapore and three days later the Board of Amatil approved an application for the allotment of 7,999,998 shares of S$1.00 each in Matila, paid to 15 cents. The shares were duly allotted to Amatil, producing a paid-up capital of S$1.2 million. The shares were allotted on the basis that the balance would be paid in calls as announced by the company. The existing two shares were also transferred to Amatil. Mr Priest and Mr Watson became directors of Matila, together with three local (Singapore) directors. On 13 October 1986 Matila's authorised share capital was increased from S$7 million to S$8 million. At about the same time a Banker's Guarantee in lieu of S$300,000
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statutory deposit was provided by Citibank NA, Singapore, in favour of the Accountant General.On 23 October 1986 Matila entered into a Management Agreement with Sedgwick Management Services Pte Ltd (``Sedgwick Singapore''), effective as from 1 September 1986. Under the agreement Sedgwick Singapore undertook to manage, on behalf of Matila
``all kinds of insurance or reinsurance business in which [Matila] may now or hereafter engage and all things necessary or incidental thereto.''
The directors of Matila, other than Mr Watson and Mr Priest, appear to have been employees of Sedgwick Singapore. One consequence of the management arrangement between Matila and Sedgwick Singapore was that the former had no employees or indeed office of its own.
The 1986-1987 Policies
On 27 October 1986 Matila issued a cover note to ``Amatil Limited and/or Subsidiary Companies'' for a composite policy, in force for the period 27 October 1986 to 30 September 1987. The composite policy covered
. Section A -- (i) products liability; and
(ii) products recall.
. Section B -- Bad debts.
The policy covered claims first made and reported during the period of insurance. There was an A$10 million limit in respect of Section A(i) and (ii) for all claims during any one period of insurance and a deductible of $100,000 for any one claim. The equivalent limit in respect of Section B was A$2 million, with a deductible of A$3.25 million in any one period of insurance. The ``minimum and deposit premium'' was A$5 million, reflecting the following premium rates:
. Section A (i) 0.4% on estimated tobacco companies'
turnover;
(ii) 0.015% on estimated total turnover;
. Section B 0.015% on total turnover.
On 31 October 1986, Matila issued to Amatil ``and all subsidiary Companies'' a cover note in respect of ``Industrial Special Risks/ Consequential Loss'', covering all real or personal property belonging to the insured, or for which the insured was responsible. The indemnity period was 24 months and the limit of insurance was A$40 million for any single loss. The premium was adjustable on declared values, to be closed on a net basis at 0.04675%.
A debit note from Matila, addressed to Sedgwick in Sydney indicates that Amatil and subsidiary companies were debited with a premium in respect of the composite policy as follows:
Amount
A$
. Section A (i) product liability 4,200,000
(ii) product recall 300,000
. Section B bad debts 300,000
Amatil thereafter debited Wills with the premium of $4,200,000 attributable to the products liability health risks insurance in respect of tobacco products. The invoice noted that the premium represented 0.4% of estimated turnover of A$1,050 million.
The composite policy itself was issued by Matila in Singapore on 8 January 1987. The policy was originally drafted within Sedgwick Australia's office and was reviewed by Mr Watson in the same manner as had occurred with other policies taken out by Amatil. As finally issued, the policy corresponded with the cover note issued previously, except that the insured were specified as ``Subsidiary Companies of Amatil Limited'' and did not include Amatil itself. In addition, the policy was expressed to cover claims made and reported during the ``extended reporting period'', which meant the period of twelve months from expiry of the insurance period. The policy provided, inter alia, that Matila would pay to or on behalf of the insured all sums which the insured became legally liable to
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pay in respect of claims arising, or allegedly arising, out of, or attributed to, the consumption or use of tobacco products manufactured, sold or supplied by the insured. Matila was also to pay all legal costs, charges and expenses incurred in connection with claims in respect of which the insured was entitled to indemnity.Matila did not attempt to reinsure the risks covered by the composite policy, because (as Mr Watson said in evidence) Sedgwick advised that reinsurance was not available. The industrial special risks policy was, however, wholly reinsured. These policies were the only ones issued by Matila in its first year of operations. The Amatil group, including Wills, maintained insurance policies with other underwriters, as it had in previous years.
1987-1988
In June 1987, Mr Michie sought Mr Moule's advice as to the availability and cost of professional indemnity insurance (to cover negligent advice to third parties) and of machinery breakdown insurance. Mr Moule advised that no local underwriters were interested in issuing a professional indemnity policy separate from the public and products liability policy. He suggested either placing the existing composite policy with new underwriters or asking Matila in Singapore to issue a separate professional indemnity policy. Mr Moule also advised that, in the absence of loss statistics, no premium indications could be obtained for machinery breakdown insurance. Mr Michie responded by asking Mr Moule to obtain a quotation from Matila for professional indemnity insurance.
At about the same time, Mr Michie asked Mr Moule to ascertain Matila's terms for renewing the composite policy, with increased liability limits. The letter concluded as follows:
``Would you please advise whether the quotations obtained are considered competitive and if not, what action you would recommend regarding the obtaining of alternative quotations.''
On 17 September 1987 Mr Moule informed Mr Michie of the terms offered by Matila. He advised that, for renewal of the existing terms, the premium rates would be unchanged. Loadings were required to reduce deductibles or to increase limits. Matila had refused to increase the aggregate limit beyond A$12.5 million, but was prepared to offer professional indemnity insurance. Mr Moule expressed the view that, with the exception of one particular quotation, the terms offered were ``reasonable particularly as cover is not available from other underwriters''.
In the event, Mr Michie (using Amatil letterhead) advised Mr Moule that it had been decided to increase the sum insured under Section A of the composite policy to A$12.5 million (as offered by Matila), with a deductible of $10,000 for any one claim. The policy was to continue to cover products recall and bad debts (the cover for bad debts being $2 million in aggregate, subject to a deductible of $3.25 million). Professional indemnity cover, subject to a limit of $5 million, was also sought. The premiums payable in respect of the 1987/1988 year in respect of this coverage were as follows:
Composite Policy
Turnover Rate Total
A(i) Health Risks $1,152m at .424% $4,884,480
(ii) Products Recall $2,357m at .015% $ 374,763
B Bad Debts $2,357m at .015% $ 353,550
----------
$5,612,793
----------
In addition, $100,000 was payable in respect of the professional indemnity cover, producing a total premium of A$5,712,793.
In due course, Amatil was debited with the amount of $5,712,793, and in turn, Amatil invoiced Wills with the premium attributable to the renewal of the health risk liability insurance component of the composite policy. The health risk premium of $4,884,480 was charged, as to $4,664,000, to Wills in Australia, while the balance was charged to what seems to have been an associated company in Papua New Guinea. On 10 November 1987 Sedgwick
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forwarded to Mr Michie a renewal endorsement received from Matila. In June 1988 Matila issued the composite policy, naming the insured as the subsidiary companies of Amatil for a period of insurance commencing on 30 September 1987 and concluding on 30 September 1988.At some time during the 1987/1988 year, Matila issued two new policies. The first was a marine policy relating to the reinsurance of 25% of the risk covered by an existing policy issued by QBE to Amatil. Matila wholly reinsured this risk on the London market. The second new policy was a motor policy, covering material damage and third party liability, subject to a limit of A$10,000 for any one loss and A$1,000,000 in the aggregate.
1988-1989
In July 1988 Mr Moule wrote to Mr Tyler of Sedgwick International in London, in the following terms:
``Amatil still have an exclusion in their products liability cover with QBE in respect of claims relating to cancer and heart disease alleged to be caused by tobacco products. This particular exposure has been insured separately with Matila Insurance Pte Limited, the Amatil insurance subsidiary located in Singapore, but the client is not happy with the level of premium cost.
The premium for 1987/88 is estimated at A$4,884,480 (being turnover $A1,152m @.424%) and cover is on a claims made basis with a twelve months extended reporting period. The indemnity limit is A$12.5m (aggregate).
To date, no legal actions have been instituted against Amatil Subsidiaries in Australia.
In 1986 a Mrs Scanlon was granted leave to proceed in a negligence action against Rothmans, a completely separate company, but the action was subsequently withdrawn. Rothman's legal costs were reportedly in the vicinity of $750,000.
Rothmans were more recently also joined in an action by an employee of the Commonwealth Government against his employer alleging illness resulting from an exposure to asbestos which was exacerbated through smoking. It is understood this action was also discontinued.
There have been several other instances where employees have taken action against their employers for illness allegedly due to passive smoking in their workplace but these have been settled for relatively minor amounts (highest known settlement $20,000).
You will be aware of the recent Cipollone verdict against Liggett Group Inc. in USA, which is currently being appealed.
Would you please approach underwriters for an alternative quotation to the Matila cover. We are hoping that the softening of market conditions will enable you to obtain a quote this year where it was unobtainable in previous years.
If you cannot obtain a quote on the same cover terms as existing, you might try for an excess layer, perhaps $5m or $10m in excess of $10m - all in the aggregate. Would you also give us an indication of the difficulty or ease you expect in completing 100% because it might be possible for Matila to act as a co-insurer.''
In Mr Tyler's absence on leave the request was dealt with by two of his staff, Messrs Brennan and Best. Their telex to Mr Moule, dated 12 August 1988, contained the following response:
``RYL 15.7 HAVE NOW COMPLETED OUR CANVASS OF THE LONDON MARKET IN AN ATTEMPT TO OBTAIN SOME TERMS FOR THE HEALTH HAZARD LIABILITY OF THE ABOVE CLIENT.
REGRET THAT DESPITE APPROACHING A LARGE NUMBER OF LEAD UNDERWRITERS IN BOTH LLOYDS AND THE COMPANY MARKET (ENCOMPASSING NOT ONLY OUR MOST RESPECTED LEADERS BUT ALSO THOSE WITH AN EYE FOR THE UNUSUAL OR RISKY PROPOSITION, WE HAVE BEEN UNABLE TO ACHIEVE ANY TERMS STOP UNDERWRITERS EACH RAISED A SERIES OF OBJECTIONS MANY OF WHICH WERE COMMON TO THEM ALL INCLUDING:
- 1. I WAS UNABLE TO LOCATE A LEADER WHO DID NOT HAVE THE HEALTH HAZARD OF CIGARETTE MANUFACTURERS EXCLUDED ON
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HIS TREATY REINSURANCE PROTECTION.- THIS WOULD RESTRICT ANY AVAILABLE CAPACITY TO A NETT LINE BASIS AND WOULD MAKE A.DLRS 12.5M AN UNATTAINABLE TARGET STOP EVEN COMPLETION OF SIGNIFICANTLY LOWER LIMITS OF INDEMNITY WOULD BE UNLIKELY.
- YOU MAY BE AWARE THAT A SMALL (AND DECREASING) NUMBER OF TOBACCO MANUFACTURERS DO HAVE A LIMITED FORM OF HEALTH HAZARD COVER STOP I SHOULD ADVISE THAT THIS IS THE RESULT OF THE MARKETS COMMITMENT TO CONTINUITY ON ACCOUNTS WHERE THIS TYPE OF HAZARD HAS BEEN INCLUDED FOR MANY YEARS STOP.
- EVEN THESE (IN THE CURRENT MEDIA CLIMATE REGARDING THE DANGERS OF TOBACCO SMOKING) ARE UNDER THE CLOSEST SCRUTINY AND REVIEW.
- 2. I AM SURE THAT YOU ARE AWARE THAT THE POTENTIAL LIABILITY OF CIGARETTE MANUFACTURERS IS CURRENTLY A PARTICULARLY SENSITIVE ISSUE NOT JUST IN AUSTRALIA AND THE USA BUT ALSO HERE IN BRITAIN STOP
- ...
- EVEN ON A CLAIMS MADE BASIS UNDERWRITERS WOULD NOT FEEL SAFE AS THE FIRST SUCCESSFUL CLAIM COULD RESULT IN A FLOOD OF SIMILAR ACTIONS WHICH WOULD ALL HAVE TO BE NOTIFIED AS POTENTIAL CLAIMS ON THAT YEAR.
- 3. UNDERWRITERS ARE ALSO CONSCIOUS OF PUBLIC OPINION BEING INCREASINGLY ANTI SMOKING/ANTI TOBACCO COMPANIES STOP THIS COULD HAVE AN ADVERSE EFFECT ON DEFENDING A SUIT.
- 4. EVEN IF A SUIT WERE ULTIMATELY UNSUCCESSFUL THE COST OF FIGHTING IT COULD BE CONSIDERABLE STOP
- ...
NOTWITHSTANDING EACH OF THE ABOVE POINTS EVEN IF SOME FORM OF HEALTH RISK COVER WERE TO BE AVAILABLE IT IS ABSOLUTELY CLEAR THE CURRENT RATE OF POINT 424 PERCENT ON TURNOVER WOULD BE EXCEEDED STOP AMATIL HAVE A GOOD DEAL AND WE CANNOT IMPROVE UPON IT.''
Until July 1988 Amatil had neither received nor reported any claim based on damage to health arising out of the use of tobacco. On 11 July 1988 Wills received a handwritten letter from a person claiming to be a smoker who had suffered heart attacks as a result of smoking cigarettes produced by Wills. Wills forwarded the letter to Mr Moule. On 5 September 1988 Mr Michie advised Mr Moule that Wills had learned of the possibility of their being joined in an action by a smoker alleging illness as the result of exposure to asbestos and smoking cigarettes distributed by Wills.
On 13 September 1988 Mr Michie asked Mr Moule to ascertain the terms required to renew the composite policy for the period 30 September 1988 to 1 November 1989 (the additional month's coverage being necessary to bring the policy into line with the Group's financial year). Mr Michie asked for the extended reporting period to be increased to 24 months and sought, as an alternative, a quotation for a limit on liability of A$15 million for Part A of the policy. The letter concluded as follows:
``It is noted that the premium rates payable under this policy have remained unchanged since inception, except for variations resulting from increases in the sums insured. Since October, 1986 only two apparently relatively minor claims have been notified under Section A(i) and in the circumstances, it would seem reasonable for us to expect a reduction in rating. Would you please take this matter up with the Underwriter on our behalf as part of your renewal negotiations.''
On 29 September 1988 Mr Watson advised Wills' Director of Accounting that Sedgwick
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had been unable to locate alternative markets for coverage under the composite policy, but without success. He also advised that Sedgwick Australia had negotiated ``the best terms possible with the existing underwriter taking into account the favourable claims history''. The result was that Matila had offered an increased limit of A$15 million at a rate of 0.414% of turnover on an estimated annual turnover of A$1,171,000. This produced an estimated annual premium of A$4.85 million (A$5.273 million for 13 months) and a minimum and deposit premium of A$4.6 million (A$4.9 million). Mr Watson recommended the increased coverage.In the result, Wills decided to accept increased coverage of A$15 million for a premium (for 13 months) of A$4.9 million, adjustable at 0.414% of sales. The premium charged by Matila for product recall insurance for the 13 month period was set at $400,000, adjustable at 0.159% of sales. The premium for professional indemnity was set at a flat $95,000. Bad debts coverage was provided by Matila for the same period under a separate policy, at a premium of A$750,000. Matila also renewed the motor and marine policies.
In April 1989 a reorganisation of Amatil was announced. In consequence of that reorganisation, at midnight on 2 August 1989, Wills ceased to be a subsidiary of Amatil. Under the terms of its Singapore licence Matila could no longer provide coverage to Amatil or its subsidiaries. Accordingly, arrangements were made for coverage under the composite and credit risk policy to cease on 2 August 1989. By that date the only two incidents that had been reported, which could have resulted in claims under the health risks section of the composite policy, were the two claims to which reference has already been made. Under the terms agreed between Matila and Amatil, Matila retained no liability in respect of those claims after 2 August 1989.
Matila's Underwriting Results
Matila recorded substantial underwriting profits, in large measure because no claims were made by Wills under the health risk component of the composite policy.
The following table shows underwriting profits for
- • the 13 month period from 7 October 1986 (the date of incorporation) to 31 October 1987;
- • the financial years 1 November 1987 to 31 October 1988; and
- • the 14 month period from 1 November 1988 to 31 December 1989.
The figures are in Singapore dollars.
1987 1988 1989
$ $ November 1
1988 to
December 31
1989
$
+---------------------------------------+
UNDERWRITING INCOME: | | | |
| | | |
Gross premium | 15,191,528 | 10,203,494 | 616,480 |
Less: | | | |
Reinsurance premium | 121,692 | 218,225 | ( 826,136) |
+---------------------------------------+
Net premium 15,069,836 9,985,269 ( 209,656)
Interest income from investment
of underwriting funds 1,085,963 2,051,330 5,352,061
Commission income 11,749 13,184 200,971
---------- ---------- ---------
16,167,548 12,049,783 5,343,376
+---------------------------------------+
UNDERWRITING OUTGO: | | | |
Claims incurred | 1,931,986 | 2,266,992 | ( 3,110,662)|
Underwriting expenses of | | | |
management | 67,500 | 56,913 | 77,583 |
Foreign currency exchange | | | |
(gain)/loss | 66,350 |( 2,741,596)| 2,477,155 |
Transfer to reserve for | | | |
unexpired risks | 7,675,613 | 2,158,455 | ( 8,609,400)|
+---------------------------------------+
9,741,449 1,740,764 ( 9,165,324)
---------- ---------- -----------
UNDERWRITING PROFIT FOR THE YEAR
TRANSFERRED TO PROFIT AND LOSS
ACCOUNT 6,426,099 10,309,019 14,508,700
---------- ---------- -----------
In 1986-1987 the net profit after tax was S$5,677,745. In 1987-1988 the net profit after tax was S$9,657,394 and in 1988-1989 S$12,858,650 (after allowing for the writing back of reserves because Matila was no longer at risk).
Further Findings
As will be seen, the Commissioner's submissions, although they were put in various ways, centred on the proposition that in essence, the outgoings incurred by Wills constituted an inter-group arrangement designed to create a capital fund to meet any claims by consumers of Wills' tobacco products. Before turning to the submissions, it is appropriate to make a number of findings, in addition to those set out in the account of events already given. These findings flow largely from that account, although I have also taken into account the oral and affidavit evidence, especially of Mr Watson, Mr Priest and Mr Michie.
- • The proposal to establish a captive insurer in Singapore was made by Amatil substantially for the reasons set out in Mr Moule's report of August 1986. The decision by Amatil was based substantially on the objectives articulated in that report.
- • Although Amatil, through Mr Watson, Mr Priest and the Board, appreciated that there were, or might be, taxation advantages for the Group in establishing a Singapore captive insurer, this was not the principal or dominant motive underlying the proposal. The principal motives were commercial or managerial in character. They included more effective risk management through self- insurance; a reduction in the Group's dependence on external insurers; retention of investment earnings and reserves within the Group; and better access to the reinsurance market, insofar as reinsurance was available.
- • The decision by Wills to seek coverage from Matila for the health risks associated with tobacco consumption was made in consequence of the unavailability to Wills of cover for those risks on the open insurance market. The decision was made principally because Mr Watson and Mr Priest formed the view that it was in Wills' commercial interests that coverage be obtained against the health risks. They also took the view that a captive insurer would be likely to handle claims more competently than would a general insurer.
- • The premiums paid by Wills to Matila in respect of the health risks coverage under the composite policy were not unreasonable, having regard to the nature of the risks covered, the limits of Matila's liability and the state of the insurance market relating to such risks. This finding takes account of the apparent magnitude of the premiums in relation to Matila's maximum exposure from time to time under the health risks component of the composite policy.
- • Wills acted on what Mr Watson and Mr Priest regarded as competent expert advice in agreeing to the premiums payable to Matila in respect of health risks coverage for 1986-1987 and the successive years. Genuine attempts were made on behalf of
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Wills to secure more favourable terms from Matila. - • The composite policy, as renewed from time to time, was intended by Wills, Matila and Amatil to operate in accordance with its terms. The coverage provided by Matila, pursuant to the health risks component of the policy, was such that Matila could have suffered an underwriting loss had consumers made claims against Wills and had Wills sought indemnity under the policy.
I should mention two matters specifically in relation to these further findings.
First, Mr Shaw's cross-examination of Mr Watson was designed, in part, using Mr Shaw's words, to demonstrate that Matila ``was at no risk'' under the composite policy. The contention put to Mr Watson was that the premiums were so large that, given the inevitable delay on processing claims and the after-tax earnings from the fund created within Matila, no payout could exceed the premiums plus accrued interest. Mr Watson rejected this contention, primarily on the basis that claims were unpredictable and that the policy provided coverage against legal expenses incurred in defending actions brought against Wills. Mr Watson had formed the view that legal expenses might be very large and would be incurred by Wills soon after claims were made against it. Mr Tyler's evidence tended to support that of Mr Watson, as indeed did contemporary documentation referring to the possibility of Matila incurring an underwriting loss. Moreover, the limits on Matila's liability for health risk cover under the composite policy were increased from A$10 million in 1986-1987 to A$15 million in 1988-1989.
Mr Shaw placed some reliance on the projected profit and loss statement and projected balance sheet prepared by Sedgwick Australia in support of the proposal to establish a captive insurer. He suggested that the projections showed that the inevitable result of the policy being issued was that Matila would accumulate reserves. The projections were based on a set of stated assumptions, including a single claim of A$3 million in the second year ``to demonstrate the affect [sic] on the accounts''. There is nothing to suggest, however, that the assumption that a single claim would be paid over a three year period represented an informed attempt to forecast the extent of likely claims under the composite policy. It was clear to all concerned that past experience was not a reliable guide to the extent of likely future claims. That is the major reason why coverage for health risks was not available on the open insurance market. Accordingly, I do not think that the projections assist materially in determining whether Matila was at risk, or thought to be at risk, of suffering an underwriting loss in respect of the health cover provided under the composite policy.
No expert evidence, actuarial or otherwise, was adduced to contradict that given by Mr Watson and Mr Tyler. Mr Watson's evidence, in my view, establishes that the decision- makers within Wills formed the opinion that, despite the magnitude of the premiums to be charged by Matila for the health risk cover, it was commercially worthwhile for Wills to secure the coverage provided by the composite policy. Mr Tyler's evidence, together with the contemporary documentation, justifies a finding that a premium/policy limit ratio of about 1:2 for the 1986-1987 year was reasonable, having regard to the nature of the risk and the state of the insurance market. (The premium actually charged was somewhat less.) The same conclusion applies to the premium charged for subsequent years.
Of course, as events turned out, Matila made substantial underwriting profits over a period of about three years, very largely because no claims were made by Wills under the health risk component of the composite policy. But this does not show that the risk accepted by Matila was not of a very high order. Nor does it show that, had the risk insured against eventuated, Matila would not have suffered an indemnity loss. I therefore do not accept the suggestion that Matila was not at risk of an underwriting loss in respect of the health risk cover provided by the composite policy, during the currency of that policy.
Secondly, it was put to Mr Watson that Matila made no attempt to reinsure the health risk under the composite policy. Mr Watson's response, which I accept, was that Matila itself made no attempt on the advice of Sedgwick Australia that such cover was unavailable. This does not detract from the conclusion that one reason for the establishment of Matila as a captive insurer was that it was thought to provide better access to the reinsurance market, including in relation to coverage for health risks. Nor does it detract from the conclusion
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which I think should be reached, that Matila would have considered reinsurance opportunities had they been available.The submissions
The Commissioner's Arguments: s. 51(1)
The Commissioner contended that the deductibility of the premiums depended on an assessment of the character of the expenditure from a practical and business point of view, rather than a juristic classification of the legal rights employed in the process:
Hallstroms Pty Ltd v FC of T (1946) 8 ATD 190, at 196; (1946) 72 CLR 634, at 648, per Dixon J.;
Fletcher & Ors v FC of T 91 ATC 4950, at 4958; (1991) 173 CLR 1, at 18-19. The authorities established that the magnitude of an expenditure may be such as to call into question its proper character, in particular, whether the expenditure was incurred in gaining or producing assessable income is to be regarded as an outgoing of a capital nature: Fletcher, at ATC 4958; CLR 18-19;
Ure v FC of T 81 ATC 4100, at 4104 and 4110; (1981) 50 FLR 219 (FCA/FC), at 223, per Brennan J; 233-234 per Deane and Sheppard JJ.
In order to constitute expenditure necessarily incurred in carrying on a business, the claimed deductions had to be ``clearly appropriate or adapted for'' the purpose of gaining assessable income:
Ronpibon Tin NL & Tongkah Compound NL v FC of T (1949) 8 ATD 431, at 435; (1949) 78 CLR 47, at 56. The premiums in this case were not appropriate or adapted for this purpose. In order to assess the essential character of the voluntary outgoings, it was necessary to take account of the relationship between Wills and Matila; the fact that the risk was practically uninsurable on the open market; the size of the premiums compared with the limit of liability, and the fact that there was no distribution of risk outside the Amatil group of companies. Taking these factors into account, the contracts of insurance and the premiums paid amounted to an inter-group arrangement for the creation of a capital fund to meet possible future liabilities. The purpose of the exercise was to set up a capital fund which, from a practical and business point of view, was to remain available to Wills to meet any health risk claims that might materialise. The premiums were therefore not outgoings of the kind within either of the limbs of s. 51(1).
Alternatively, Mr Shaw submitted that the outgoings were of a capital nature and thus not deductible under s. 51(1). The so-called ``insurance'' was an Amatil Group undertaking, calculated to create a fund from which future claims could be met. The case was similar to
Ransburg Australia Pty Ltd v FC of T 80 ATC 4114; (1980) 47 FLR 177 (FCA/FC), where it was held that payments made by a taxpayer to another company, in return for an agreement by the letter to indemnify the taxpayer against liability for holiday and long service leave payments, were not outgoings of revenue, but capital set aside to provide for revenue contingencies.
The Commissioner's Arguments: Part IVA
The Commissioner submitted that the scheme had been correctly identified as constituting the arrangements and transactions by which Wills ``purportedly'' had obtained insurance coverage for its health risk. The tax benefit obtained by Wills was the obtaining of deductions which it would not have received had the scheme not been entered into.
The Commissioner further submitted that the dominant purpose to be attributed to the parties, in entering into or carrying out the scheme, was that of obtaining the tax benefit. Mr Shaw pointed to a number of particular matters which suggested that this was the appropriate conclusion to reach. These were identified as follows:
- ``(a) The risk was practically uninsurable.
- (b) The decision to insure was practically made by Amatil and it obtained the entire commercial advantage of the money being placed in Matila, save for any advantage obtained by Wills under the `policy'.
- (c) Priest was a director both of Amatil and Matila and Watson was the insurance and risk manager in Amatil for the groups and a director of Matila; two directors of Amatil were also directors of Wills.
- (d) If the scheme was not entered into, no deduction would have been available to Wills for the amount of the premiums.
- (e) By reason of the scheme being carried out Wills obtained indemnity up to $10m in respect of tobacco health risks, but if it had set aside a fund itself of the same amount as the premiums and invested that fund, the fund (subject to the effect of taxation on the income it produced) would have been
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sufficient to reach the amount insured at the earliest time it was likely to be payable. To the extent that no health risk has ever manifested itself as a claim, the benefit of the payment of the premiums would be enjoyed by Matila itself and indirectly by Amatil, both companies closely related to Wills.- (f) The substance of the scheme involved the creation of Matila of a capital fund substantially by the payments by Wills in the form of `premiums', themselves sufficient or almost sufficient to fund the largest possible claim under the policy when there was no certainty of any such claims arising.
- (g) Only a few risks were insured with Matila and in order for it to be viable financially it was necessary for the premiums to be very large.
- (h) The scheme was hurriedly entered into just before the end of the fiscal year for Amatil and Wills.
- (i) Matila's funds were managed by a group fund manager, Amatil Hong Kong.
- (j) Tax in Singapore was payable at 10% on premium income and received a concessional rate of 10% on all income derived by Matila from offshore business.
- (k) The health risk of Wills was not reinsured and only Amatil companies were insured by Matila and substantially only for uninsurable risks.
- (l) Matila itself had no employees, office space or other separate existence; it was essentially an empty shell.''
Since the dominant purpose was to obtain a tax benefit, the terms of s. 177D were satisfied and the Commissioner's determinations were not open to challenge.
Mr Shaw expressly disclaimed any contention that the arrangements, or any part of them, could be described as a sham.
Wills' Arguments: s. 51(1)
Mr Ellicott submitted that the composite policies issued by Matila to Wills were properly to be regarded as contracts of insurance. There was the requisite element of speculation for both insured and insurer and the size of the premium in relation to risk was no barrier to the policies being so characterised. Similarly, the relationship between Wills and Matila did not prevent the policies being regarded as contracts of insurance. As such, the premiums paid by Wills were incurred in carrying on a business for the purpose of gaining or producing income.
Mr Ellicott submitted that there was a real and substantial connection between the outgoings and Wills' business. That business consisted of the manufacture and marketing of tobacco products for human consumption. The outgoings were premiums in return for coverage against claims made for disease of the human body arising out of or attributed to the use or consumption of such products. Given the character and scope of Wills' business, the objective purpose of the premiums was both ``incidental'' and ``relevant'' to the business operations, as required by the test laid down in
FC of T v DP Smith 81 ATC 4114, at 4117; (1981) 147 CLR 578, at 585-586. Insofar as Wills' subjective motive was relevant to whether the outgoings were necessarily incurred in carrying on the business, the evidence was that the motive supported the objectively assessed purpose.
Mr Ellicott also contended that the outgoings could not be characterised as of a capital nature. The loss insured against was on revenue account because any such losses arose directly out of Wills' business operations, and these were the very activities which produced Wills' assessable income. He distinguished Ransburg on the ground that payments made by the taxpayer in that case were not in respect of coverage against a loss which might not occur, but in respect of obligations which inevitably had to be met.
Wills' Submissions: Part IVA
Wills did not dispute that there was a scheme in place, within the broad definition adopted by s. 177A(1) of the ITA. Wills disputed, however, that, had the health risk not been insured with Matila, it was reasonable to expect that cover would have been obtained through some other means, such as a captive insurer located elsewhere, even in Australia. It was not reasonable to expect that the only course open to Wills was to create an internal fund to meet possible claims. Even if Wills did adopt that course, it may have been able to claim deductions in account of liabilities incurred but not yet reported (IBNR's), just as insurers are entitled to claim.
Wills further submitted that this was not a scheme entered into or carried out for the
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dominant purpose of enabling Wills or Amatil to obtain a tax benefit in connection with the scheme. In substance, the scheme comprised transactions which were genuine and commercial and carried out in a commercial and business-like fashion. The policies were intended to operate in accordance with their form and there was nothing to suggest that the risk was not to be met by Matila. When the matters specified in s. 177D of the ITA were taken into account the only purpose that could be discerned was the obtaining of insurance cover for health risks created by Wills' products. This was a commercial purpose, directed to Wills' business ends.Reasoning
Section 51(1)
The competing arguments put by Mr Shaw and Mr Ellicott did not clearly distinguish between the first and second limbs of s. 51(1). The two limbs have different origins, the first being derived from s. 23(1)(a) of the Income Tax Assessment Act 1922 (Cth) and the second added in 1936: see Ronpibon v FC of T, at ATD 434; CLR 55;
Magna Alloys & Research Pty Ltd v FC of T 80 ATC 4542, at 4545; (1980) 33 ALR 213 (FCA/FC), at 216, per Brennan J. The two limbs are neither mutually exclusive nor co-extensive. There are cases which fall outside the first limb, which is primarily concerned with expenditure incurred in the actual course of producing assessable income, yet are within the second:
John Fairfax & Sons Pty Ltd v FC of T (1959) 11 ATD 510, at 514; (1958-1959) 101 CLR 30, at 40, per Fullagar J. Nonetheless, there is a substantial degree of overlap between the two limbs, at least where the taxpayer conducts a business. In Ronpibon v FC of T the Court said this (at ATD 435; CLR 56):
``The alternative in s. 51(1)... covers a wide description of activities. But in actual working it can add but little to the operation of the leading words, `losses or outgoings to the extent to which they are incurred in gaining or producing the assessable income'. No doubt the expression `in carrying on a business for the purpose of gaining or producing' lays down a test that is different from that implied by the words `in gaining or producing'. But these latter words have a very wide operation and will cover almost all the ground occupied by the alternative. The words `such income' mean `income of that description or kind' and perhaps they should be understood to refer not to the assessable income of the accounting period but to assessable income generally. If they were so interpreted, they would cover a case where the business had not yet produced or had failed to produce assessable income and the alternative would then itself suffice to authorize the deduction of a loss made in a distinct business.''
As Brennan J. noted in Magna Alloys v FC of T, at ATC 4545; ALR 216-217, the requirement in the second limb, that expenditure be incurred in carrying on a business, parallels the requirement in the first limb that the expenditure be incurred in gaining or producing the assessable income. His Honour in that case cited the following passage from the judgment of Mason J. in
AGC (Advances) Ltd v FC of T 75 ATC 4057, at 4072; (1974-1975) 132 CLR 175, at 198:
``Thus in the Ronpibon case (at p 57) the Court stated that `to come within the initial part of the sub-section it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income'. So also it may be said that it is enough to satisfy the second part of the sub-section that the occasion of the loss or outgoing is to be found in the carrying on of a business for the production of assessable income.''
It is sufficient in the present case to focus on the second limb of s. 51(1), which refers to losses and outgoings necessarily incurred in carrying on a business for the purposes of gaining or producing assessable income. It is well established that the words ``for the purposes of gaining or producing such income'' qualify the words ``carrying on a business'': Ronpibon v FC of T, at ATD 436; CLR 57; Magna Alloys v FC of T, at ATC 4557; ALR 232, per Deane and Fisher JJ. It is also well established that the requirement that the outgoing be ``necessarily'' incurred in carrying on the business does not mean that the outgoing must be unavoidable or compelled.
``What is required is that the relevant expenditure be appropriate and adapted for the ends of the business carried on for the purpose of earning assessable income (see Ronpibon Tin NL and Tongkah Compound NL v FC of T, supra, at pp 55-56; FC of T v Snowden & Willson Pty Ltd, supra, at pp 444, 447). For practical purposes and within
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the limits of reasonable human conduct, it is for the man who is carrying on the business to be the judge of what outgoings are necessarily to be incurred (FC of T v Snowden & Willson Pty Ltd, supra, at p 444). It is no part of the function of the Act or of those who administer it to dictate to taxpayers in what business they shall engage or how to run their business profitably or economically. `The Act must operate upon the result of a taxpayer's activities as it finds them': per Williams J, Tweddle v FC of T (1942) 7 ATD 186 at p 190;...''
Magna Alloys v FC of T, at ATC 4557; ALR 232-233.
In Magna Alloys v FC of T itself, the Full Federal Court considered whether legal costs paid by a company, to defend directors and agents of the company and the company itself against charges of criminal conspiracy were allowable deductions. The charges were laid in connection with the company's practice of making gifts to customers, including employees of government departments. The trial judge rejected the company's claim for a deduction, in large measure because he found that the directors' dominant motive in authorising the payments was to protect their own position.
In their joint judgment, Deane and Fisher JJ. distinguished between the subjective motive of a taxpayer in incurring an outgoing and the question posed by the second limb of s. 51(1). Their Honours pointed out that there are some circumstances in which the taxpayer's subjective motive will be of little assistance in determining whether an outgoing was necessarily incurred in carrying on a business: 80 ATC at 4558; 33 ALR at 233-234. This is so when the outgoing is largely involuntary, in the sense that it is not optional or discretionary, as in
Charles Moore & Co (WA) Pty Ltd v FC of T (1956) 11 ATD 147, at 148-149; (1956) 95 CLR 344, at 351 (where moneys were stolen in an armed robbery). See also
Putnin v FC of T 91 ATC 4097, at 4101; (1990) 98 ALR 13 (FCA/FC), at 18. In these circumstances the nature of the outgoing will be determined by objective considerations.
Where the outgoing is voluntary, the taxpayer's motive may be relevant in determining whether it was necessarily incurred in carrying on the relevant business: 80 ATC at 4559; 33 ALR at 234. Their Honours said this (at ATC 4559; ALR 234-235):
``Where an outgoing which was not involuntary has actually achieved the purpose for which it was incurred or where the connection between an outgoing and the relevant business is direct and obvious, there will ordinarily be little practical point in distinguishing between characterization of the outgoing by reference to what is achieved and characterization in the light of the purposes and objects of those responsible for incurring it. Thus, in the ordinary case of a payment under a contract, the nature of the outgoing will commonly be determined by reference to the contractual quid pro quo. Cases where the outgoing does not achieve its intended purpose or where the connection with the business is indirect and remote demonstrate, however, the need to distinguish between the character of an outgoing determined merely by reference to objective factors and its character determined in the light of subjective purpose in any precise formulation of the ingredients of the second limb of sec 51(1).''
Their Honours concluded that there was no necessary dichotomy between what can properly be regarded as incidental and relevant to the business ends of a business and that which advances the personal interests of directors and employees or even their relatives and friends: 80 ATC 4542, at 4560; 33 ALR 213, at 236-237. In their view, the voluntary outgoing was reasonably capable of being seen as desirable from the point of view of pursuit of the business ends of the business and was so seen by the decision-makers. The reality was that the interests of the directors and employees, and those of the company, were interwoven.
In FC of T v DP Smith 81 ATC 4114; (1981) 147 CLR 578, the High Court held that premiums paid by a salaried medical practitioner, in respect of disability insurance providing for monthly payments in the event of loss of income, were allowable as deductions under the first limb of s. 51(1). The majority cited the observations of the High Court in Moore v FC of T (11 ATD at 148-149; 95 CLR at 351), that premiums for insurance against losses caused by robbery would be an allowable deduction, because of the connection of the payment with the operations that produce the assessable income. The majority continued (at ATC 4117; CLR 585-586):
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``The section does not require that the purpose of the expenditure shall be the gaining of the income of that year, so long as it was made in the given year and is incidental and relevant to the operations or activities regularly carried on for the production of income. What is incidental and relevant in the sense mentioned falls to be determined not by reference to the certainty or likelihood of the outgoing resulting in the generation of income but to its nature and character and generally to its connection with the operations which more directly gain or produce the assessable income.''
This test was applied by Rogers J. to the second limb of s. 51(1) in
FC of T v Adler 81 ATC 4687; (1981) 55 FLR 294 (S Ct NSW). His Honour held that a director's liability and indemnity policy, taken out with the holding company of which the taxpayer was Chairman of Directors, was incidental and relevant to carrying on the taxpayer's business of company director.
As the High Court said in Fletcher & Ors v FC of T, at ATC 4957; CLR 17, in relation to the first limb of s. 51(1), whether an outgoing was wholly or partly incurred in gaining or producing assessable income is a question of characterisation. The same comment applies to the second limb of s. 51(1). The task of characterisation is assisted by the tests formulated in FC of T v DP Smith and Magna Alloys v FC of T. The tests must be understood as referring to a genuine and not colourable relationship between the whole of the expenditure and the carrying on of the business for the purpose of gaining or producing assessable income: cf Fletcher & Ors v FC of T, at ATC 4958; CLR 18.
In my view, the premiums paid to Matila by Wills in respect of the health risks should be characterised as necessarily incurred in carrying on Wills' business as a manufacturer and distributor of tobacco products. The composite policy was intended to and did provide coverage against major risks arising out of its business operations. This follows from the terms of the policy and the circumstances which gave rise to the perceived need to obtain coverage from a related company. The risks insured against went to the very heart of Wills' business. The absence of available coverage through the open insurance market created a commercial need to develop a strategy for covering those risks. The connection between the premiums and the conduct of Wills' business is, in my opinion, clear.
It is of course true that the premiums were, on the face of matters, very large and were paid to an associated company. I accept that there are circumstances in which the disproportionate or excessive nature of expenditure can suggest that the outgoings were not made for the purpose of obtaining assessable income or for the purposes of the business incurring the expenditure:
FC of T v Phillips 78 ATC 4361, at 4368; (1978) 20 ALR 607 (FCA/FC), at 617, per Fisher J. No doubt this is particularly so where the payments are made to an associate of the taxpayer:
FC of T v South Australia Battery Makers Pty Ltd 78 ATC 4412, at 4427; (1977-1978) 140 CLR 645, at 672, per Murphy J. But the premiums paid in the present case were not disproportionate to the advantage gained by Wills, namely, coverage within the limits specified by the health risks component of the composite policy. On the findings I have made, the premiums were not unreasonable for the coverage obtained and there were valid commercial reasons for Wills to seek coverage. There were also valid commercial reasons for Amatil to establish a captive insurer to provide that coverage.
The fact that, in the event, Wills made no claims under the health risks component of the composite policy is not to the point. Had Wills made any such claims, it was entitled, assuming the claims to be covered by the policy, to be indemnified by Matila, subject to the terms of the policy. There was nothing in the evidence to suggest that Matila would have been unable to comply with its obligations, if necessary by calling up the balance of unpaid capital. Viewed objectively, the premiums were reasonably capable of being seen as desirable or appropriate from the point of view of Wills' business. They were seen in this way by the decision-makers within Wills.
It was, of course, open to Wills to consider alternative strategies to deal with the difficulty presented by the uninsurability of the health risks on the open market. Mr Watson acknowledged that he had considered alternatives, including setting aside a fund to meet claims. Had that strategy been adopted, Wills would have had no deduction available in respect of premiums. But Wills did not choose
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that route for reasons that were capable of being regarded as commercially valid. Indeed, the choice made might have resulted in Wills obtaining a higher assessable income than if no insurance coverage had been obtained. This might have occurred had a number of consumers instituted proceedings against Wills, thereby causing it to claim indemnity under the policy in respect of legal costs and damages. The question is not what strategies Wills might have adopted to cope with the difficulty in obtaining health risk coverage, but whether the outgoings it in fact incurred were allowable deductions under s. 51(1) of the ITA.One other point should be mentioned. Mr Ellicott's argument, as I understood it, proceeded on the basis that the composite policy, insofar as it related to health risks, was correctly classified as a contract of insurance, since it met the criteria laid down in the authorities for such a contract:
Prudential Insurance Co v Commissioners of Inland Revenue [1904] 2 KB 658, at 663;
NM Superannuation Pty Ltd v Young (1993) 41 FCR 182, at 187-189, per Burchett J; at 195-202 per Hill J;
Australian Health Insurance Association Ltd v Esso Australia Ltd (1993) 41 FCR 450 (FCA/FC). I do not doubt that the composite policy is properly classified as a contract of insurance. But I do not think that this conclusion, of itself, necessarily means that the premiums constitute allowable deductions under s. 51(1). There may be circumstances in which premiums paid in respect of an insurance are not allowable deductions for the purposes of s. 51(1). For example, the contingency insured against may be insufficiently related to the taxpayer's business in gaining assessable income. The critical question must be whether the outgoings satisfy the criteria specified in s. 51(1). For the reasons I have given, I think the outgoings in the present case did so.
A Capital Fund?
Mr Shaw submitted that, even if the premiums paid by Wills to Matila were within the first or second limbs of s. 51(1), they were outgoings of a capital nature. He relied on a passage in Professor R.W. Parson's work, Income Taxation in Australia (1985), para. 6.212:
``A premium paid on a policy of insurance will not be deductible if the premium was paid, not to maintain the business against the cost of an outgoing, but to ensure that there would be funds to meet that outgoing.''
Professor Parsons cites Ransburg v FC of T in support of this proposition and Mr Shaw relied on the same case in support of his submission.
In Ransburg, the taxpayer was a subsidiary of Wormald International Ltd. The taxpayer entered an agreement with another company, Manipa Pty Ltd, whose three shareholders included Wormald and whose business was limited to making agreements with subsidiaries of its shareholders. The taxpayer claimed deductions for payments made to Manipa pursuant to agreements made respectively, on 30 June 1975 and 30 June 1976. The majority (Deane and Fisher JJ., Lockhart J. dissenting) held that all payments were not deductible because they were of a capital nature.
The taxpayer contended that, under the agreements, Manipa undertook to indemnify the taxpayer in respect of holding and long service leave payments to its employees. Fisher J., with whose judgment Deane J. agreed, said (at ATC 4117; FLR 181) that, if it was proper so to characterise the payments, it would be hard to deny that they were deductible. However, his Honour did not accept that this was the correct characterisation. The agreements provided that, when the taxpayer met its specified liabilities, Manipa would make the agreed payments. His Honour took the view that, despite the use of the word ``indemnify'' in the agreement, the payments were not true indemnities. This was because the taxpayer was to receive a predetermined amount, or the amount in fact paid to employees, whichever was the lesser. Furthermore, neither payment was annual or recurring in nature; rather it was made once and for all and each agreement was complete in itself (at ATC 4117; FLR 182). Accordingly, his Honour characterised each payment as a capital payment in the nature of an investment. Each payment was made in order to establish a fund which would be available to the taxpayer, at least in part, when it made payments to employees.
Fisher J. drew a distinction between the payments made by the taxpayer and certain kinds of insurance premiums (at ATC 4119-4120; FLR 185):
``... the question arises whether they were made on revenue or capital account. In this regard it is apparent that the payments have no similarity to payments of premiums
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under policies of workmen's compensation insurance, sickness or accident insurance. Such insurance is a true indemnity against a loss which may never occur. These premiums are paid regularly and periodically and the continued protection of the insured is conditional upon periodical payment of premiums under the policy. Upon the conclusion of the period to which a premium relates, the protection of the insured thereafter is conditional upon payment of the premium for the ensuing period. No rights or entitlements vest in the insured in consequence of the payment of the earlier premium except in reference to happenings during the period to which the premium relates. If there are no such happenings, the payment of the premium has not produced any continuing advantage of benefit.''
In the light of the findings I have made, there are very clear differences between Ransburg v FC of T and the present case. The payments made by Wills to Amatil, as the documentation makes clear, were by way of premiums for coverage against health risks created by Wills' business operations. There is nothing to suggest that the documentation was not intended to operate in accordance with its terms. On the contrary, the evidence supports the conclusion that the composite policy, as renewed from time to time, was intended to provide coverage to Wills subject to the policy limits. The risks covered by the policy, unlike the liabilities in Ransburg v FC of T, may or may not have materialised. If they did, Wills was entitled to be indemnified in accordance with the terms of the composite policy. The premiums were paid regularly and were subject to reassessment by the insurer and the insured, as is commonly the case with insurance renewals. The premiums were not one-off payments providing a pre- determined benefit to the tax-payer. Accordingly, Ransburg v FC of T does not compel or even suggest the conclusion that the premiums paid by Wills are to be characterised as capital payments in the nature of an investment, or payments to establish a capital fund to meet future liabilities. Indeed, the reasoning of the majority suggests otherwise.
In my view, the payments made by Wills to Matila are properly characterised as insurance premiums, intended to secure coverage against liability to consumers of the products manufactured or distributed by it. Premiums paid to secure protection against loss of a capital asset have long been held to be on revenue account, notwithstanding that the loss insured against is a capital loss:
Usher's Wiltshire Brewery Ltd v Bruce [1915] AC 433 (HL), at 465, 471. The reason, as was said by Bowen CJ and Burchett J. in
Australian National Hotels Limited v FC of T 88 ATC 4627, at 4634; (1988) 19 FCR 234 (FCA/FC), at 241, is that the
``... annual premiums are a recurring expense outlaid in order to make the investment safe, and thereby secure its continuance. A business that did not incur those outlays, as a practical matter, could not be sure of retaining the investment and thereby earning its income.''
The present case is a fortiori since, as Mr Shaw conceded in argument, any liability incurred by Wills to consumers of its products who suffer damage to their health could be regarded as a loss on revenue account:
Ash v FC of T; Commission of Taxation (NSW) v Ash (1938) 5 ATD 76, at 81; (1938) 61 CLR 263, at 277, per Rich J.
It is true that Wills paid premiums to an associated company. It is also true, as Mr Shaw pointed out, that the premiums paid by Wills in respect of cover for health risks formed the great bulk of Matila's gross income, apart from interest earned in its accumulated funds. These facts are material in assessing the true character of the claimed deductions and, in particular, whether they should be classified as of a capital nature. As was said by the Court in
GRE Insurance Ltd v FC of T; Unitraders Investments Pty Ltd v FC of T 92 ATC 4089, at 4094; (1992) 34 FCR 160 (FCA/FC), at 166:
``That is not to say that [the subsidiary of a holding company] should not be considered as a taxpayer in its own right. It was such a taxpayer and its activities should be so considered. Nevertheless, the part which a subsidiary plays in affairs which concern its holding company, or in the group [of] which both companies form a part, may throw light upon the character of the activities of the subsidiary.''
But the fact that premiums are paid to a related company is no necessary barrier to them being classified as allowable deductions under s. 51(1) or as payments on account of revenue. In Ransburg v FC of T the majority
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contemplated that, if the payments had been made to obtain a true indemnity against future liabilities, they would have been allowable deductions, notwithstanding that they were made on the last day of the financial year to a related company (albeit not a wholly owned subsidiary of a common parent). In Australian National Hotels v FC of T it was held that premiums paid by the taxpayer to a finance company within the same group, in order to insure against exchange losses in relation to a foreign currency loan, were allowable deductions and not of a capital nature. The arrangements were entered into (as in the present case) because attempts to obtain cover from other sources had failed. So far as appears from the report, the finance company had never previously provided similar coverage. Neither counsel nor the Court in that case suggested that the fact that the premiums had been paid to a related company meant that they were capital in nature. In response to an argument based on s. 260 of the ITA, the majority characterised the insurance arrangement (at ATC 4634; FCR 242) as ``a commercial solution to a commercial problem''.The payments in the present case were made by Wills to Matila because no insurance cover was available to Wills through underwriters operating in the open market. A judgment was made that it was in Wills' commercial interests to obtain cover against liability to consumers of tobacco products. The premiums, despite this magnitude, were not unreasonable for the cover obtained and were determined with the benefit of expert advice to Wills. Matila was established as a licensed insurer in Singapore, complying with the statutory requirements in that jurisdiction. Had Wills incurred liabilities to consumers, or been the subject of legal proceedings instituted by consumers, it would have called on the amendments provided by the policy. Matila's insurance business was confined to a limited group of policies largely because most coverage required by Wills and other companies within the Amatil Group could still be obtained from underwriters in the open market. Of course, Matila was limited by the requirements of Singapore law to insuring risks of its parent and related companies. In these circumstances, in my view, the fact that the premiums were paid by Wills to a related company, which conducted only a limited business as an insurer, does not justify the payments being characterised as outgoings of a capital nature.
Part IVA
In
FC of T v Spotless Services Limited & Anor 95 ATC 4775 (FCA/FC), Cooper J., with whom Northrop J. agreed, stated that the operation of Part IVA falls to be determined by answering a series of questions in sequence. These are (at 4802):
- ``(a) Was there in existence a `scheme' as defined by s. 177A of the ITAA?
- (b) Was there a `tax benefit' as defined by s. 177C?
- (c) If there was a scheme, was it a scheme to which the Part applied as determined by s. 177D?''
The final question in the present case, the answer to which flows from the first three, is whether the Commissioner was entitled to determine that Wills' assessable income for each of the relevant years should include the tax benefit, comprising the deductions claimed by Wills, in respect of the premiums paid by it to Matila.
As I have indicated, the parties were not in dispute about question (a). The case was fought on the basis that the scheme identified by the Commissioner was a scheme for the purposes of Part IVA. The parties were at issue in relation to questions (b) and (c).
Was There a Scheme to which Part IVA Applied?
Despite Cooper J.'s observations, it is convenient in this case to address question (c) first. That question can be re-framed, in the circumstances of the present case, as whether, in the light of the findings I have made, any or all of Wills, Amatil or Matila entered into or carried out the scheme for the dominant purpose of enabling Wills to obtain a tax benefit in connection with the scheme. The tax benefit is the obtaining of deductions which Wills would not have been able to claim, had the scheme not been entered into or carried out. I approach this question on the assumption that the answer to (b) is that Wills did obtain a tax benefit from the scheme, in the form of allowable deductions for the premiums paid by it to Matila.
In FC of T v Peabody, the High Court said this about challenges to the exercise of the
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Commissioner's discretion under Part IVA (at ATC 4669; CLR 382):``Under s 177F(1), the Commissioner's discretion to cancel a tax benefit extends only to a tax benefit obtained in connection with a scheme to which Pt IVA applies. The existence of the discretion is not made to depend upon the Commissioner's opinion or satisfaction that there is a tax benefit or that, if there is a tax benefit, it was obtained in connection with a Pt IVA scheme. Those are posited as objective facts.''
(Footnote omitted.)
Section 177D(b) specifies eight matters to which regard must be had in determining whether it would be concluded that Wills or Amatil entered the scheme for the dominant purpose of obtaining a tax benefit for Wills. Both Mr Shaw and Mr Ellicott agreed that the only matters to be taken into account in making the determination required by s. 177D(b) were those specified in s. 177D(b)(i)-(viii). Those matters are to be determined objectively, having regard to the particular circumstances of the taxpayers, as is the ascertainment of the purpose of the person or persons entering or carrying out the scheme: FC of T v Spotless, at 4810.
In applying the criteria laid down in s. 177D(b) of the ITA to the scheme, it is necessary to recall both the nature of the scheme identified by the Commissioner and the circumstances of the scheme, as I have found them. The scheme identified by the Commissioner commenced with the plan to establish Matila as a captive insurer, principally to provide insurance to Wills in respect of which cover was not available from third party insurers at acceptable rates. The scheme therefore included the steps preparatory to the formation of Matila in Singapore and to the issue of the composite policy by Matila to Wills.
The decision by Amatil to incorporate a captive insurer in Singapore reflected commercial difficulties facing the Group. These difficulties included, but were not limited to, the inability of the Group to obtain insurance in relation to certain risks, notably the health risks flowing from consumption or use of the tobacco products manufactured and marketed by Wills. The difficulties created by the hardening insurance market were genuine and perceived to be such by the decision-makers within Wills and Amatil. They led to a detailed consideration of the proposal for a captive insurer, as a practical solution to the problem.
Section 177D(b)(i) requires regard to be paid to the ``manner in which the scheme was entered into or carried out''. Although the idea for a captive insurer originated within Amatil, the detailed proposal for a Singapore captive was formulated by Amatil's recently appointed broker. The proposal identified a number of commercial advantages, from the perspective of the Group, in establishing the captive. It is true, as Mr Watson acknowledged in cross examination, that not all of these advantages came to fruition. For example, Matila was unable to gain access to the reinsurance market to offset the whole or a portion of the health risk component of the composite policy, because no reinsurance was available. Nonetheless, the creation and continued operations of the captive insurer were designed to obtain for the Amatil Group the benefits identified in the Sedgwick Group. There were also clearly identified commercial advantages in the captive being located in Singapore. These included the availability of an appropriate infrastructure and suitable investment opportunities. One further advantage was Singapore's relatively low tax rate, but this was only one of a number specified in the Sedgwick report. Furthermore, the captive was incorporated and its capital structured in accordance with the requirements of the Singapore authorities. Matila's affairs were clearly conducted in a business-like fashion and (so I infer from the documentation) in conformity with the law of Singapore. Matila's insurance business was limited in scope, but restrictions were inherent in the conditions imposed by the Singapore authorities. Moreover, the scope of Matila's activities reflected the nature of the commercial needs of Wills and other companies in the Group.
The composite policy was issued and renewed as the result of negotiations between Wills and Amatil, on the one hand, and Matila on the other. It goes too far to characterise their dealings as being entirely at arm's length. The two companies were related and had two directors in common. They also had brokers who were associated (Sedgwick Australia and Sedgwick Singapore). Even so, the documentation suggests that each party pursued its own commercial interests in the negotiations relating to premium rates and policy terms.
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There was nothing in the evidence to contradict the inferences to be drawn from the documentation.The form and substance of the scheme (s. 177D(b)(ii)) do not suggest, in my opinion, that the dominant purpose of the parties to the scheme was to enable Wills to obtain a tax benefit. In form, Matila, as a licensed insurer, issued a policy indemnifying Wills against liability and legal costs in respect of claims arising out of the consumption or use of Wills' tobacco products. The risk against which indemnity was provided (subject to policy limits) was a genuine one. The terms of the policy were appropriate to the cover required by Wills. Premiums were paid by, or charged to, Wills, in accordance with the terms of the policy. Had claims been made against Wills, it would have relied on the indemnity provided by the policy, as renewed from time to time. There is nothing in the evidence to suggest that Matila would have been unable to meet any claims made by Wills, once the paid up capital and the capital available through further calls were taken into account.
Mr Shaw contended that the scheme involved the establishment of a fund within Matila, by means of the premiums paid by Wills. He also submitted that the substance of the scheme was the creation of a capital fund ``sufficient or almost sufficient to fund the largest possible claim under the policy when there was no certainty of any such claims arising''. For reasons I have already given, I do not think that the facts support this characterisation of the scheme. The premiums paid by Wills, despite their magnitude, were not disproportionate to the risk against which indemnity was provided. Matila was at risk of suffering an underwriting loss if a substantial number of claims, involving significant legal costs, were made against Wills.
Mr Shaw also contended that Matila was essentially an ``empty shell'', because it had no employees, office space or other separate facilities. But that was because Matila determined to conduct its business through Sedgwick Singapore, under terms negotiated between the two. The documentary evidence suggests that this was a decision based on a judgment as to the most efficient and economic means of conducting Matila's business. It may also have been required by the Singapore authorities. There is nothing to suggest the decision was made for other reasons. In my view, the evidence does not warrant describing Matila as an ``empty shell''. Similarly, the fact that Matila's funds were managed by Amatil Hong Kong does not detract from the conclusion that Matila was conducting its business in what was regarded as a systematic and efficient fashion.
Section 177D(b)(iii) requires the time at which the scheme was entered into and the length of the period during which the scheme was carried out to be considered. Mr Shaw pointed out that Matila was incorporated and the composite policy issued shortly before the end of the close of the financial year for Amatil and Wills. Amatil's 1986-1987 financial year commenced on 1 November 1986. But the arrangements carried into effect shortly before that date had been the subject of consideration, at least since Sedgwick's memorandum of August 1986. No doubt it was convenient to implement the arrangements before the commencement of the new financial year. I do not think that, at least without further evidence, the timing of the arrangement suggests that it was for the dominant purpose of securing a tax benefit to Wills.
The scheme continued until Wills ceased to be a subsidiary of Amatil. At that point, Matila was no longer able to provide coverage, because of the terms of its licence to operate in Singapore. There is nothing to suggest that, but for this change of circumstances, the cover would not have continued, subject to Matila and Wills agreeing upon suitable terms.
It is convenient to consider s. 177D(b)(iv)- (vi) together. The factors referred to in these sub-paragraphs are as follows:
- ``(iv) the result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme;
- (v) any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme;
- (vi) any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme.''
But for Part IVA, Wills would be entitled to deduct the premiums paid to Matila. To that
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extent, its financial position has changed. Matila's position has also changed, because it has been able to build up reserves, largely out of the premiums paid by Wills. But on the findings I have made Wills received something in return for the premiums paid by it, namely an indemnity under the composite policy. The price it paid for that indemnity, viewed from a commercial perspective, was not unreasonable.Of course, as events turned out, Wills had no occasion to call on the indemnity. Had it done so, the result of the scheme would have been to limit losses that, if borne by Wills, would have reduced its assessable income. In those circumstances, depending on the extent of the losses, the result of the scheme could have been to increase Wills' net income for tax purposes. Thus the change in Wills' financial position was not merely due to the scheme, but to the fact that no claims were made against it during the currency of the composite policy. Similarly, the change in Matila's position was not simply due to the scheme, but resulted from the absence of any claim by Wills to an indemnity under the policy. Had Wills made such claims, Matila would have been required to make payments under the policy which, depending on their timing and magnitude, might have resulted in a loss.
Mr Shaw did not suggest that there was any other relevant consequence for Wills, Amatil or Matila, of the scheme having been entered into or carried out, that suggested a conclusion that the dominant purpose of the scheme was to obtain a tax benefit for Wills (s.177D(b)(vii)).
The final matter, referred to in s. 177D(b)(viii), is the nature of any connection (whether of a business or any other nature) between Wills, as the ``relevant taxpayer'', and Amatil or Matila, as parties whose financial position has changed, or might reasonably be expected to change, as a result of the scheme. The fact that the three companies are part of the same group is a matter to be carefully weighted in assessing whether the purpose of the scheme was to enable Wills to obtain a tax benefit. Where arrangements have been made between related companies, careful scrutiny is necessary to ascertain, for example, whether the documentation accurately reflects what the parties contemplate will occur and whether expressed reasons for a particular course of action are to be taken at face value. In this case, as I have said earlier, the reasons for establishing Matila as a captive insurer in Singapore are accurately recorded in the contemporary documentation. The terms of the composite policy were accepted by Wills and Matila, primarily as the means of overcoming a commercial difficulty faced by Wills, flowing from the unavailability of health risks cover on the open market. The policy governed the relationship between Wills and Matila and provided Wills with the underwriting cover it considered important.
In my view, having regard to the matters specified in s. 177D(b) of the ITA, the scheme identified by the Commissioner had two principal commercial purposes. First, the scheme enabled Wills to obtain indemnity against health risks that otherwise was not available to it. Secondly, the scheme provided the Amatil Group with a number of commercial advantages. These included more effective risk management and claims handling, better chances of gaining access to the reinsurance market and the opportunity to retain the underwriting profits that might have flowed (and in fact did flow) from a somewhat speculative underwriting venture.
One of the benefits of the scheme, as understood by the participants, was the possible tax advantages. The contemporary documentation referred to the relatively low tax rates in Singapore (although not to any benefit accruing to Wills by reason for the premiums being allowable deductions). But any taxation advantage was incidental to the principal objectives. Specifically, in my view, it cannot be concluded that any of the participants entered into the scheme or carried it out for the claimed purpose of enabling Wills to obtain a tax benefit.
It seems to me that the observations of Hill J. in Peabody v FC of T are apposite to the present case (at ATC 4117-4118; CLR 548-549):
``Clearly enough, the whole scheme, as formulated, was entered into or carried out by Mr Peabody with a dominant commercial purpose, namely, the acquisition of shares from Mr Kleinschmidt and the flotation of a public company. The fact that an element of that scheme had a tax advantage does not detract from the dominant purpose of Mr Peabody in relation to the scheme as a whole. The matters to which regard may be had under s. 177D clearly direct attention on the one hand to the commercial elements of
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the scheme and on the other hand to the tax elements. They require a balancing of the two. But the factors which predominate in the present scheme considered as a whole are purely commercial. Once the scheme is analysed as encompassing the acquisition of shares, the financing of those shares and the ultimate flotation of a public company, it is hard to see, in a case such as the present, how the relevant conclusion as to purpose could have been drawn. Part IVA would seldom, if ever, operate to permit the Commissioner to make a determination, carrying with it as it does an automatic penalty upon a taxpayer assessed, where the overall transaction is in every way commercial, although containing some element which has been selected to reduce the tax payable. Part IVA is no more applicable to such a case than was its predecessor, s. 260.''
Nothing said in the High Court casts doubt on these observations, which, in my respectful opinion, reflect the policy underlying Part IVA, as stated in the Second Reading Speech.
It also seems to me that this is a stronger case for the taxpayer than FC of T v Spotless. The majority there identified the scheme in two ways. The broader description was as follows (at 4805):
``... the proposal of the taxpayer to invest $40m on deposit in the Cook Islands and pay Cook Islands withholding tax on the interest earned, and the taking of all necessary steps to implement the proposal.''
The advantage to the taxpayer was that s. 23(q) of the ITA, as it then stood, had the effect that income derived by a resident from a source outside Australia was exempt from Australian tax, if it was subject to tax in the country from which it was derived.
The majority took the view that, where the activity under consideration is a bona fide investment of capital funds, the tax payable on the interest is, for the purpose of deciding whether or not to undertake particular investment, a relevant consideration. Cooper J. concluded (at 4811-4812) that:
``Where by the operation of the foreign taxation laws and the existing Australian taxation laws the net return after the payment of all applicable tax and other costs of the investment is higher investing offshore than within Australia, it cannot be said that, objectively, the dominant purpose of the investor investing offshore is to get a tax benefit, the purpose is to obtain the maximum return on the money invested after the payment of all applicable costs, including tax.''
Beaumont J. dissented. His Honour considered (at 4797) that the course of action adopted by the taxpayer was ``fiscally or tax driven''. It followed from the form and substance of the scheme that the taxpayer entered into it to obtain a particular tax benefit - that is, an exemption for Australian tax of the amount of interest remaining after the Cook Islands withholding tax was deducted (at 4797). It was not a fair description of the transactions that the taxation aspects were ``merely incidental or consequential'' (at 4798):
``The fiscal aspects were highlighted in the contemporary documentation. They were clearly at the forefront of the parties' consideration. Without taxation benefits, the proposal made no sense.''
The present case is different. Fiscal aspects were not highlighted in the contemporary documentation. No mention was made of the particular tax benefit said by the Commissioner to accrue to Wills. Taxation issues were not at the forefront of the parties' consideration. Without taxation benefits, the proposal still made commercial sense.
Taxation Benefit
In view of the conclusion I have reached, it is not necessary to consider whether Wills obtained a tax benefit in connection with the scheme. However, I shall briefly refer to this issue. A tax benefit is obtained if a deduction is allowable to the taxpayer in relation to a year of income, where the whole or a part of that deduction would not have been allowable, or might reasonably be expected not to have been allowable to the taxpayer, had the scheme not been entered into or carried out: s. 177C(1)(b). In FC of T v Peabody, the High Court said (at ATC 4671; CLR 385) that a
``... reasonable expectation requires more than a possibility. It involves a prediction as to events which would have taken place if the relevant scheme had not been entered into or carried out and the prediction must be sufficiently reliable for it to be regarded as reasonable.''
(Footnote omitted.)
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See also FC of T v Spotless at 4806-4809.
The difficulty in this case is that the evidence did not explore what would have happened had the scheme not been entered into or carried out. To a large extent the answer must be speculative.
Mr Ellicott submitted that it was a reasonable expectation that Wills would have obtained coverage from another captive. However, as I understood him, he accepted that Wills' position would not have been advanced had that captive been located outside Australia. This is because there would simply have been a new scheme relevantly identical to the scheme actually implemented, with only the location of the captive being different.
Alternatively, Mr Ellicott submitted that, even if Wills had acted as a self insurer, it ``may well'' have claimed deductions by making allowances for claims incurred but not reported and claiming deductions in respect of those allowances.
On the evidence before me, I would have concluded that a reasonable prediction, had the scheme not been entered [into] or carried out, is that Wills would have simply taken the risk of claims being made against it by persons claiming to be adversely affected by its cigarette products. The various alternatives posed by Mr Ellicott are all possibilities, but I could not regard any of them as a reliable prediction, at least in the absence of further evidence. It must be remembered that the options available to Wills and Amatil were limited, because the health risk was not insurable on the open market. There was no evidence to suggest that Wills would have made allowances for IBNR's if the proposal for a Singapore based captive did not proceed. Moreover, s. 14ZZO of the Taxation Administration Act 1953 (Cth) imposes upon an appellant the burden of proving that the taxation decision under challenge is excessive.
Accordingly, if it had been necessary to do so, I would have found that Wills obtained a taxation benefit in connection with the scheme.
Conclusion
Wills has established that the Commission erred in making each of the determinations pursuant to Part IVA of the ITA. The appeals should be allowed and the objection decisions in respect of the amended assessments for Wills for the years ended 31 October 1986, 1987, 1988 and 1989 should be set aside. Wills' objections to the amended assessments should be allowed and the matters should be remitted to the Commissioner for determination according to law. The Commissioner should pay Wills' costs of the appeals.
THE COURT ORDERS THAT:
1. The appeals in NG 262, NG 263, NG 264 and NG 265 of 1994 be allowed.
2. The decisions of the respondent in respect of the amended assessments for the applicant for the years ending 31 October 1986, 1987, 1988 and 1989 be set aside.
3. The matters be remitted to the respondent for determination according to law.
4. The respondent is to pay the applicant's costs in the appeals.
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