Edited version of your written advice

Authorisation Number: 1012697756508

Ruling

Subject: Loss portfolio transfer with capped adverse development cover arrangement (LPT/ADC)

Question 1

Is the consideration paid by an insurer to a reinsurer for a LPT/ADC deductible under section 321-25 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

Is the consideration paid by an insurer to a reinsurer for a LPT/ADC deductible under section 8-1 of the ITAA 1997?

Answer

Yes

Question 3

Do the prepayment rules under section 82KZMA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the scheme?

Answer

No

This ruling applies for the following periods:

1 January 2014 to 31 December 2014

The scheme commences in:

2014

Relevant facts and circumstances

1. The arrangement is referred to as a proposed loss portfolio transfer with capped adverse development cover arrangement ("LPT/ADC").

2. The contract provides for the transfer of the risk of loss from the occurrence of events insured. The transfer of risk is made through the indemnity to the insurer in respect of the portfolio transferred.

3. The proposed LPT/ADC reinsurance contract itself is proportional, i.e. it constitutes retrospective quota share reinsurance with an aggregate cap.

4. For accounting purposes, the net result of the arrangement would be that the net outstanding claims liability of the insurer would decrease to reflect the reinsurance cover obtained by the reinsurer under the portfolio transfer.

5. The consideration to be paid by the insurer to the reinsurer is market value consideration for the risks transferred under the LPT/ADC.

6. The LPT/ADC will be accepted by APRA as reinsurance which is not a limited risk transfer.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 27-5

Income Tax Assessment Act 1997 Division 321

Income Tax Assessment Act 1997 section 321-10

Income Tax Assessment Act 1997 section 321-15

Income Tax Assessment Act 1997 section 321-20

Income Tax Assessment Act 1997 section 321-25

Income Tax Assessment Act 1997 section 321-45

Income Tax Assessment Act 1997 section 321-55

Income Tax Assessment Act 1997 section 321-60

Income Tax Assessment Act 1936 Subdivision H of Division 3 of Part III

Income Tax Assessment Act 1936 section 82KZL

Income Tax Assessment Act 1936 paragraph 82KZL(1)(f)

Income Tax Assessment Act 1936 paragraph 82KZL(2)(c)

Income Tax Assessment Act 1936 section 82KZMA

Income Tax Assessment Act 1936 paragraph 82KZMA(1)(b)

Income Tax Assessment Act 1936 subsection 82KZMA(3)

Income Tax Assessment Act 1936 paragraph 82KZMA(3)(c)

Income Tax Assessment Act 1936 subsection 82KZMA(4)

Income Tax Assessment Act 1936 section 82KZMD

Income Tax Assessment Act 1936 section 82KZMA

Reasons for decision

Question 1

Is the consideration paid by an insurer to a reinsurer for a LPT/ADC deductible under section 321-25 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

No, the consideration paid by an insurer to a reinsurer for a LPT/ADC is not deductible under section 321-25 of the ITAA 1997.

Reasons for decision

The consideration under the LPT/ADC broadly secures for the insurer the right to obtain funds to meet the cost of claims at such time as they need to be met. Its amount is worked out by reference to factors including the estimated quantum of claims that will need to be paid, but the ultimate timing and amount of those payments is not known. The consideration has only a contingent and indirect connection with claims, being a payment to assume risk in respect of those claims rather than a payment to actually or effectively discharge them.

On the latter point, it could be that in some cases an amount paid to a third party which in practical terms frees the insurer of liability under those claims (in a similar way to an actual settlement) is deductible under section 321-25 of the ITAA 1997. However, the LPT/ADC is not a case of that kind. Although the insurer will be indemnified to the extent provided for under the LPT/ADC, it will retain claims handling obligations and will remain primarily liable for their payment.

It is considered that the consideration under the LPT/ADC is more in the nature of general business expenditure whose deductibility or otherwise should be determined under the tests of the general deduction provision rather than section 321-25 of the ITAA 1997.

In terms of the overall policy of the legislation, the potentially indirect nexus between payments made to provide for the eventual payment of claims (and their diverse nature), and the actual amounts expended in paying claims, is a strong rationale for making the deductibility of such payments subject to the tests of the general deduction provision.

In conclusion, the consideration under the LPT/ADC is not deductible to the insurer under section 321-25 of the ITAA 1997 as it is not 'in respect of claims' in the relevant sense.

Question 2

Is the consideration paid by an insurer to a reinsurer for a LPT/ADC deductible under section 8-1 of the ITAA 1997?

Summary

Yes, the consideration paid by an insurer to a reinsurer for a LPT/ADC is deductible under section 8-1 of the ITAA 1997.

Reasons for decision

Under section 8-1 of the ITAA 1997, a deduction is allowed for losses or outgoings to the extent that the loss or outgoing is incurred in gaining or producing assessable income, or is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, a deduction is not allowed under section 8-1 of the ITAA 1997 where the loss or outgoing is of a capital nature.

Payments made by an insurer to a reinsurer to assume the insurer's underwriting risk in respect of the policies it has issued are typically in the nature of outgoings necessarily incurred in carrying on a business of general insurance to produce assessable income. Subject to the features of a particular arrangement meeting the requirements of the general deduction provision, the consideration for such risk transfers is deductible under section 8-1 of the ITAA 1997.

Where an arrangement with another insurer is essentially in the nature of an investment rather than a risk transfer, the amount paid is likely to be of a capital nature rather than a deductible business expense. In Ransburg Australia Pty. Limited v. Federal Commissioner of Taxation 80 ATC 4114 (1980) 10 ATR 663 (1980) 29 ALR 433 (1980) 47 FLR 177 Fisher J, in the Full Federal Court majority rejecting the claim, made the following statement at 80 ATC 4116:

"The object for which the outgoings in the present matters were incurred was to procure for the taxpayer at some future date funds which it could apply for the purposes of its business or which could replace funds so applied. Putting to one side the question of any excess of the amounts received over the amounts outlaid, those outgoings represented matters of capital and not of revenue. They represented capital set aside to provide for revenue contingencies of the business rather than outgoings of revenue incurred in meeting such contingencies. They were not deductible pursuant to sec. 51(1) of the [1936] Act."

By contrast, the consideration for the LPT/ADC provides the insurer with, and indemnity for, future claims, and that it represents, in the language of Fisher J, outgoings of revenue in incurred in meeting the contingencies of the insurer's business.

Here, there is a direct commercial and business nexus between the consideration under the LPT/ADC and the premium income of the insurer which is assessable under section 321-45 of the ITAA 1997.

Under the terms of the LPT/ADC, the reinsurer will indemnify the insurer and assume risk under the relevant policies, net of existing reinsurance, up to a limit which the applicant advises would transfer risk up to a 99.5% probability of sufficiency. The consideration for this indemnity would represent the market value of this risk transfer, and thus would all be expended for the relevant purpose of providing coverage for that risk.

The full amount of the consideration would have been expended in the course of the business operations, rather than being a capital investment. The insurer would have no entitlement to an actual or effective return of the amount, but only to payments under the terms of the indemnity dependent upon the timing and net amount of claims ultimately payable.

Taking into account the features of the arrangement ruled upon, it is concluded that the consideration under the LPT/AC would be deductible under section 8-1 of the ITAA 1997.

Question 3

Do the prepayment rules under section 82KZMA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the scheme?

Summary

No, the prepayment rules under section 82KZMA of the ITAA 1936 do not apply to the scheme.

Reasons for decision

It remains to decide the potential application of the prepayment rules in Subdivision H of Division 3 of Part III of the ITAA 1936 by reference to the wording of the relevant provisions interpreted in the context of the overall statutory scheme.

Interaction of Subdivision H of the ITAA 1936 and Division 321 of the ITAA 1997

Broadly, Subdivision H of the ITAA 1936 relates to expenditure incurred under agreements which is "incurred in return for doing a thing under the agreement that is not wholly done within the expenditure year": see subsection 82KZMA(3) of the ITAA 1936.

When otherwise deductible expenditure meets the requirements of section 82KZMA of the ITAA 1936, the deduction is deferred under section 82KZMD of the ITAA 1936 so that it is progressively allowed over the duration of the "eligible service period" to which the expenditure relates.

"Eligible service period" is defined in section 82KZL of the ITAA 1936 in terms of the lesser of ten years and the time over which "the thing to be done" under the agreement is required to be done. Paragraph 82KZL(2)(c) of the ITAA 1936 provides the following further clarification in respect of insurance related expenditure:

(2) Without otherwise limiting the generality of references in this Subdivision to expenditure being incurred under an agreement in return for the doing of a thing under the agreement:

………………………………….

(c) where expenditure incurred under an agreement consists of a payment of an insurance premium or a payment of a similar kind, the expenditure shall, for the purposes of this Subdivision, be taken to be incurred in return for the provision or continued provision, as the case requires, of insurance against the risk concerned, or of a thing of a similar kind, under the agreement during the period to which the payment relates.

It is also relevant that under subsection 82KZMA(4) of the ITAA 1936, Subdivision H of the ITAA 1936 cannot apply to "excluded expenditure". According to the definition under paragraph (f) of subsection 82KZL(1) of the ITAA 1936, excluded expenditure includes the following amounts in relation to reinsurance premiums:

"excluded expenditure" means an amount of expenditure:

(f)  that has been or is incurred after 21 September 1999 by a general insurance company in payment of reinsurance premiums in respect of the reinsurance of risks covered by general insurance policies, other than reinsurance premiums that were or are paid in respect of a particular class of insurance business where, under the contract of reinsurance, the reinsurer agrees, in respect of a loss incurred by the company that is covered by the relevant policy, to pay only some or all of the excess over an agreed amount.

The wording of this exclusion is clearly connected with those amounts which are subtracted from the tax unearned premium reserve (UPR) worked out by general insurance companies under step 3 of the method statement in section 321-60 of the ITAA 1997. This UPR methodology seeks to identify the extent to which premiums relate to "risks covered by the policies in respect of later income years".

Very broadly, and relevantly, the reinsurance premiums which are both excluded from Subdivision H of the ITAA 1936 and subtracted in working out the tax UPR under Division 321 of the ITAA 1997 are "proportional" or "quota share" premiums under policies where the reinsurer agrees to indemnify the primary insurer (which may itself be a reinsurer) in respect of a specified percentage of claims under the primary insurance policies. In arrangements of this type there is a clear and direct nexus between the premium obtained by the primary insurer and the premium ceded to the reinsurer.

In arrangements of this type, the tax accounting and financial accounting rules applying to insurance companies both defer the primary insurer's premium income and reinsurance premium deduction to extent that the risk to which the policies relate arises in a later year. Both tax and accounting rules achieve this through the specific recognition of unearned premiums.

The accounting standard Australian Accounting Standards Board (AASB) 1023 General Insurance Contracts requires that premium revenue be recognised in accordance with the incidence of risk.

Similarly, both the tax and accounting rules seek to align the pattern of recognition of the direct insurer's reinsurance expense with the period of risk coverage obtained from the reinsurer. However, they use different approaches to achieving this common objective.

Under AASB 1023, recognition of both the gross premium revenue and the related reinsurance expense is deferred to the extent that it relates to risk in later years. Paragraph 10.1 states the basis for recognising outwards reinsurance expense:

10.1 Premium ceded to reinsurers shall be recognised by the cedant as outwards reinsurance expense in the statement of comprehensive income from the attachment date over the period of indemnity of the reinsurance contract in accordance with the expected pattern of the incidence of risk.

This means that the reinsurance expense would be capitalised in the accounts to the extent that it relates to risk in later years, on a comparable basis to the deferral of the inward insurance premiums by way of an unearned premium liability (UPL).

At least in respect of proportional reinsurance premiums, Division 321 of the ITAA 1997 achieves an equivalent net outcome by the following means:

• The effect of step 3 of the section 321-60 of the ITAA 1997 method statement is that only premium income net of "relevant reinsurance premiums" can be deferred to a later year in the UPL.

• Relevantly the same premiums can be deducted as incurred because they are excluded from the Subdivision H of the ITAA 1936 prepayment rules as explained above.

The combined effect is equivalent to deferring the gross premium and capitalising the reinsurance expense to the extent that they relate to risk in a later year.

To sum up, Subdivision H of the ITAA 1936 defers otherwise deductible expenditure in a comparable way to the financial accounting approach outlined above. It would therefore be inappropriate to apply it to those reinsurance premiums which have already been "indirectly" deferred by the Division 321 of the ITAA 1997 mechanisms discussed above. The exclusion of these amounts from Subdivision H of the ITAA 1936 is clearly explicable on this basis.

Application of the these principles to the consideration under the LPT/ADC arrangement

On the basis of the preceding analysis, it is concluded that the consideration paid by the insurer under the arrangement would not be within the scope of Subdivision H of the ITAA 1936. This outcome accords with both the wording and the policy intent of the relevant provisions.

Seen in isolation from the overall statutory scheme, there is ambiguity concerning whether the "thing to be done" under the LPT/ADC is the ongoing provision of funds to meet claims as they are settled or paid on the one hand, or the provision of an immediate indemnity in respect of risk relating to past years on the other. However, in the light of the overall context, the latter characterisation is to be preferred.

The LPT/ADC indemnifies the insurer in respect of policies it has issued in a way consistent with a proportional reinsurance policy, even though it only relates to outstanding claims as opposed to the more commonly encountered reinsurance entered into in respect of unexpired risk.

As shown above, the scheme of Division 321 of the ITAA 1997 is to match both inward insurance income and outward reinsurance expense with the incidence of risk under the relevant policies.

The appropriate policy outcome of allowing of allowing the deduction when it is incurred is also fully consistent with the wording of Subdivision H of the ITAA 1936 under both a literal and purposive interpretation.

Firstly, the LPT/ADC is an arrangement that needs to be recognised by way of an outstanding claim liability (OCL) reduction in respect of recoveries under section 321-20 of the ITAA 1997, and if it had related to unexpired risk, it would have also resulted in a UPR reduction for relevant reinsurance premiums under section 321-60 of the ITAA 1997. We accept that the consideration is a reinsurance premium in terms of the excluded expenditure definition of paragraph (f) of subsection 82KZL(1) of the ITAA 1936. On this basis, it is excluded from Subdivision H of the ITAA 1936 because of subsection 82KZMA(4) of the ITAA 1936.

Secondly, even if this was not the case, the combined effect of paragraphs 82KZMA(1)(b) and (3)(c) of the ITAA 1936 is that a deduction cannot be deferred under section 82KZMD of the ITAA 1936 where the "thing to be done under the agreement" is done entirely within the expenditure year. That is, Subdivision H of the ITAA 1936 cannot apply when no part of the eligible service period relates to a later year.

Read in the light of the overall scheme, the reference in paragraph 82KZL(2)(c) of the ITAA 1936 to "the provision of insurance against the risk concerned" should be read as relating to the years of the incidence of that risk rather than the years over which the resulting claims are settled.

By way of a simplified example, if a taxpayer paid three years of otherwise deductible insurance premiums in advance, the intent of Subdivision H of the ITAA 1936 would seemingly be to spread the deduction over the three years of "provision of insurance against the risk concerned", rather than the time it took to settle claims.

The latter interpretation of treating the settlement period as the service period would have the unusual result of potentially further deferring the deduction if the insurance company was tardy in meeting claims but allowing it over three years if claims were to be promptly met.

Put in another way, the insurer would be "doing a thing" for the taxpayer for the three years of the indemnity, but the efforts it put into scrutinising and verifying claims in respect of past events would be "doing a thing" for itself rather than for the taxpayer.

Applying this reasoning to the LPT/ADC, the relevant service period would be the past claims years to which the indemnity applied, and not the years over which those claims were settled. On this basis no part of the service period would relate to a later year and Subdivision H of the ITAA 1936 would have no application.

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