MERCANTILE MUTUAL INSURANCE (WORKERS' COMPENSATION) LTD & ANOR v FC of TJudges:
Both the applicant companies are members of the Mercantile Mutual Holdings Group and are engaged in the insurance industry. Other members of the Group are also involved in litigation with the respondent (``the Commissioner''). I have been advised that there are sixteen separate actions and that each of them involves the same basic issue as is presented by the two proceedings with which I am now dealing. The parties have agreed that these two proceedings are appropriate vehicles for the resolution of that issue and that the other proceedings will be resolved between them in accordance with the decision in these two proceedings.
Mercantile Mutual Insurance (Workers' Compensation) Limited (``MMIWC'') provides employers' liability insurance including workers' compensation insurance. Mercantile Mutual Insurance (Australia) Limited (``MMIA'') provides policies in respect of (inter alia) public liability and compulsory third party motor vehicle insurance. Each company is a wholly owned subsidiary of Mercantile Mutual Holdings Limited.
Each company, in the course of its business, in a year of income incurs liabilities to policy holders. Such liabilities fall into two groups, those that are settled during the year of income and are referred to as settled claims, and those which are not so settled and are referred to as outstanding claims. This litigation concerns the tax treatment of the latter claims. Outstanding claims themselves fall into two categories, first those that are reported to the company during the relevant year but are not settled before the end of the year and those which arise during the year but are not reported to the company before the end of the year. There is no dispute between the parties that liability to make payment for these claims is, relevantly, ``incurred'' in the year of income in which the events giving rise to the claim occurred. What is in contest is the correct approach to the quantification of the amounts to be allowed as deductions pursuant to s 51(1) of the Income Tax Assessment Act 1936 (Cth) (as amended) (``the Act''), in respect of such claims.
The evidence filed in the case was voluminous. However, in view of the course adopted by the parties, there has been very little reference to it. The Court is asked to determine, as a matter of law, what is the correct approach to the calculation of the amount of the deduction for outstanding claims at the end of the applicants' income year. If the Court finds in favour of the Commissioner then the appeal is to be dismissed. This will mean that the amended assessments to which appropriate objections have been taken by the applicants, will stand. If the applicants succeed, then it will be necessary for the Commissioner to reassess in respect of the income years in question. The application of MMIWC relates to the year of income ending 30 September 1989 (in lieu of 30 June 1989) and comes to the Court pursuant to s 14ZZ(c) of the Taxation Administration Act 1953 (Cth) as an appeal from the appealable objection decision of the Commissioner to disallow the applicant's objection (amended by consent) against the amended assessment issued in respect of that year. The application of MMIA is in respect of the income year ending 30 September 1992 (in lieu of 30 June 1992). Provision for self-assessment by taxpayers had then been introduced, which resulted in the course taken to bring the matter before this Court being different from that in the case of MMIWC. It is not necessary to consider this detail, as the issue raised for the Court's determination is common to both applications. In order fully to expose that issue it is necessary to refer briefly to the accounting and actuarial methods adopted by the applicants in the treatment of outstanding claims for internal accounting and for taxation purposes.
As both claims reported but not settled and claims incurred but not yet reported in the relevant fiscal year were, of necessity, unquantified, it was necessary for the applicants to arrive at an estimation of the amounts that would be needed to satisfy them in the future. Actuarial calculations were needed for this purpose. Matters such as economic inflation and increases in the level of compensation awards needed to be taken into account. In the
ATC 4817case of claims incurred but not reported, an additional estimate was needed of the number and extent of such claims, this being based upon prior claims experience in the particular insurance fields. Clearly the approach to these tasks involved highly technical actuarial methods to which, in the circumstances, it is unnecessary to make reference. The first result produced by these methods was a sum of money being an estimate of the actual amount that would be paid out in the future in settlement of outstanding claims for the particular year of incurrence. This figure has been referred to in the case, variously, as ``the final payout figure'', the ``nominal value'' of the outstanding claims or ``the face value'' of such claims.
As this figure was only an estimate, it was necessary to consider, for the purpose of prudential accounting within the applicant companies, its degree of reliability. The original estimate was described as a ``central'' estimate. This meant that statistically the figure so arrived at was intended to have an equal (ie 50 per cent) chance of ultimately proving to be too high or too low. Accordingly, as an exercise in management, it was regularly thought necessary that a margin should be added to the figure, known as the ``prudential margin'', which significantly increased the possibility that the figure arrived at would be sufficient to meet the year's outstanding claims when they fell due for payment in the future. The aggregate figure, arrived at after the completion of these processes, was the figure accepted by the management of the applicant companies for planning and accounting purposes. It was also the figure claimed as a deduction, pursuant to s 51(1) of the Act in the 1989 and 1992 years respectively. This figure is referred to as ``the inflated figure''.
In the organisation of the companies' internal finances, however, it was accepted that as the outstanding claims were to be met at dates in the future, it was not necessary that the whole of the inflated figure be put aside in the year of incurrence. All that was necessary was to set aside an amount of money which, invested at interest, would grow to a size sufficient to meet the components of the inflated figure as they fell due. This amount was, again, arrived at as a result of complicated actuarial calculation, the detail of which need not be referred to. It was referred to as the ``inflated and discounted'' figure. It was also referred to as ``the present value'' of the outstanding claims. When so arrived at it was set aside in the companies' books and appeared, as such, in the companies' accounts. It was not claimed as a deduction. As will be seen, it is the Commissioner's contention that it was this figure which was the appropriate figure for deduction and not the inflated figure. In other words, the applicant companies, following, as they contended, legal precedent, claimed deduction for the final payout figure including the prudential margin, which together made up the inflated figure, as being the ``outgoing incurred'' pursuant to s 51(1) whereas the Commissioner's contention was that the ``present value'' allowance constituted the appropriate deduction. There is no dispute in these proceedings as to the accuracy of the calculations used in arriving at these competing figures. However, it is the Commissioner's contention that the amount of the prudential margin should not have been taken into account in arriving at the figure claimed for deduction nor in arriving at the inflated and discounted figure as the ``present value'' of the claims.
The Commissioner's approach, which has led to the amended assessments in these proceedings, found expression in Taxation Ruling IT 2663 (``IT 2663''). Part B of that Ruling related to outstanding claims provisions in insurance company tax accounting, that portion of the Ruling being directed to ``determining the amount of the provision for `long-tail business'''. It is convenient, at this stage, to refer to certain portions of this Ruling. They are:-
``103. To calculate the taxable income of a general insurer for a year of income it is necessary to deduct from the premiums derived in that year:
- (a) administration and business operating expenses incurred in the year:
- (b) payments actually made during the year to satisfy claims arising from insurance contracts which earned those premiums: and
- (c) an appropriate amount or provision, arrived at by reasonable estimate, in respect of claims outstanding at the end of the year (the RACV Insurance case and Commercial Union Assurance Co of Australia Ltd v FC of T 77 ATC 4186; (1977) 7 ATR 435).
104. Outstanding claims for which provision must be made in a year of income include:
- (a) claims which have been com- municated to the insurer during the year or in earlier years but not yet paid in full: and
- (b) claims incurred but not reported (that is those which have not been communicated to the insurer before the end of the year, but which will later be communicated and paid, and in relation to which the event giving rise to the insurer's liability occurred before the end of the year).
105. The amount deductible in a year of income is a proper and reasonable estimate of claims recognised by a general insurer in the year in situations where insured events have occurred but the liabilities have not yet been extinguished.
106. The method to be used for income tax purpose to arrive at an insurer's proper and reasonable estimate of an appropriate amount of provision in respect of outstanding claims at the end of a year of income is to adopt the amount which the insurer calculates as necessary to set aside in that year out of its premium (and other) income and which, when invested, will provide sufficient funds to pay the claims in the future.''
[The reference to the RACV Insurance case is a reference to
R.A.C.V. Insurance Pty Ltd v FC of T 74 ATC 4169;  VR 1.]
IT 2663 then continued to provide a detailed explanation of why this method should be used. It referred to the fact that a general insurer's provision for outstanding claims was an allowable income tax deduction under s 51(1) as a result of RACV and
Commercial Union Assurance Company of Australia Limited v FC of T 77 ATC 4186. However, it was contended that these cases, although establishing deductibility, did not conclusively determine the basis for calculating the amount of the deduction. It was accepted that the amount to be provided in respect of ``long-tail business'' claims could be arrived at by a process of estimation but that ``[t]he question becomes what is the most appropriate method to estimate the amount of the provision''. After consideration of various possible methods IT 2663 states that ``a substantially correct reflex of a general insurer's true (net) income in respect of general insurance business it conducts in each year of income'' would involve the allowance in respect of outstanding claims of ``the additional amount set aside or `earmarked' each year to pay year end outstanding claims in the future''.
It said of the ``estimated final payout method'' that it would ``entail a deduction in the income year of the original estimate for the fully inflated cost of the claims even though any inflation element would be incurred in a later year''. Reference was made to
Owen (HM Inspector of Taxes) v Southern Railway of Peru Ltd (1956) 36 TC 602 at p 645 and to a passage in Commercial Union. I shall refer to these later.
It was on this basis that the Commissioner reassessed, disallowing the inflated figure deductions claimed and substituting, as the appropriate deduction, the present value of the claims, being the earmarked amount included in the companies' financial accounts described in argument as the inflated and discounted figure. It was the applicants' contention, as raised in the relevant objections, that this approach by the Commissioner was incorrect in law, in that the cases relied upon required that the ``inflated'' and not the ``inflated and discounted'' figure be accepted as the proper figure for deduction. I turn, then, to consider the respective cases of the applicants and the Commissioner.
The applicants' case
As it is the applicants' contention that the authorities referred to above and later cases in which they have been considered, establish, as a matter of principle, that the ``inflated'' or ``nominal value'' or ``face value'' figure is the appropriate one for deduction, it is convenient to refer to these decisions at the outset. Both RACV and Commercial Union are decisions of single judges. They have, however, been regularly followed. As has been seen, the Commissioner does not assert that they are wrongly decided. The contention is, rather, that they should be interpreted and applied in a particular way.
In RACV, the taxpayer was engaged in the business of motor vehicle insurance and compulsory third party insurance. In respect of its financial year ending 28 February 1971 it claimed a deduction in respect of ``unreported claims'' which was an estimate of its liability
ATC 4819arising out of accidents involving death or personal injury which had occurred in that financial year, but in respect of which it had received no notice. This claim was disallowed by the Commissioner of Taxation. Menhennitt J, in reliance upon earlier authority, held that an amount reasonably estimated to be the total amount which an authorised insurer would have to pay in respect of such liabilities would be deductible as a loss or outgoing in respect of that year. In the course of reaching that decision, his Honour made detailed reference to earlier decisions which have been discussed in argument in the present case. In these circumstances, it is appropriate to set out, at some length, passages from his Honour's judgment. The first such passage appears at ATC pp 4176-4177; VR pp 8 and 9 and reads as follows:-
``The Income Tax Assessment Act in imposing liability to income tax adopts the basic method of imposing taxation in respect of annual periods of time. This necessarily involves assigning to a period of a year both income and losses or liabilities. (See
Commissioner of Taxes (S.A.) v. Executor Trustee and Agency Co. of South Australia Ltd. 63 C.L.R. 108 at p. 152 to 153,
Texas Co. (Australasia) Ltd. v. FC of T 63 C.L.R. 382 at p. 465 to 466 and
Henderson v. FC of T 69 ATC 4049; 119 C.L.R. 612 at p. 649 to 650.) I have earlier pointed out that so far as income is concerned it is recognised that although premiums are received in a tax year it is inappropriate to treat the total thereof as being income of that year and an apportionment is made between that year and the subsequent year.
When there has to be considered the question whether an insurance company has incurred a loss or outgoing in a particular year that question comes to be considered in relation to the nature of the business being carried on. The essence of insurance business is that, in respect of each class of risk insured against, the insurance company aims to satisfy its liabilities to the policy holders who actually experience the risk primarily out of the total of the premiums paid by all the policy holders, most of whom normally do not experience the risk. In relation to liability insurance the insurance company is bound to indemnify its insured against his liability to a third person. Once events have occurred out of which a liability to indemnify an insured arises, it appears to me that within the meaning of sec. 51(1) of the Income Tax Assessment Act a loss or outgoing has been incurred. Events have occurred which have subjected it to a liability to indemnify its insured against his liability to a third person and the extent of that liability is capable of reasonable estimate. Where there is no real question of the liability of the insured to the third party and the only question is one of estimating damages, the fact that the quantum of the loss or outgoing is a matter of estimate and that the amount may have to be adjusted in the light of later events does not stand in the way of it being a loss or outgoing (see New Zealand Flax Investments Ltd. v. FC of T 61 C.L.R. 179 at p. 199 and Texas Co. (Australasia) Ltd. v. FC of T 63 CLR 382 at p 465 to 466) and in a case where the liability of the insured to the third party is in issue but the amount which is likely to be payable can be reasonably estimated, it is still I think true to say that within the meaning of sec. 51(1) a loss or outgoing has been incurred by the insurance company. In
Ballarat Brewing Co. Ltd. v. FC of T 82 C.L.R. 364 Fullagar J. said at p. 369-
`It is common ground that the account must, almost of necessity, proceed upon an ``accrual'' or ``earnings'' basis. It is the appropriate figure for book debts that is in question. This is in essence a matter of estimation, and (apart from express provision in the Act) it would be proper to make an allowance for bad and doubtful debts. In
Sun Insurance Office v. Clark (1912) A.C. 443, at p. 454, Lord Loreburn said:- ``There is no rule of law as to the proper way of making an estimate. There is no way of estimating which is right or wrong in itself. It is a question of fact and figures whether the way of making the estimate in any case is the best way for that case.'''
The passage I have referred to in Texas Co. (Australasia) Ltd. v. FC of T also leads to the conclusion that where an adjustment of an estimate is necessary in the light of later events it is permissible to take the amount of the adjustment into account in the year when it is made.
The conclusions I have stated are I think reinforced by the consideration that under sec. 51(1) a loss or outgoing is a deduction to the extent to which it is incurred in gaining or producing the assessable income. The liability to indemnify in respect of events occurring in the year of income is it seems to me properly to be regarded as incurred in gaining or producing the assessable income of that year because it is out of that year's premiums that the liability is to be met.''
In considering ``what do and do not constitute losses and outgoings incurred'' his Honour referred to
FC of T v James Flood Pty Ltd (1953) 10 ATD 240 at p 244; (1953) 88 CLR 492 at pp 506-508 where the judgment of Dixon CJ and Webb, Fullagar, Kitto and Taylor JJ read as follows:-
``... For under our law the facts must satisfy the expression `losses and outgoings incurred'. These words perhaps are but little more precise than the word `established' or the expression used above `definitively committed'. But they do not admit of the deduction of charges unless, in the course of gaining or producing the assessable income or carrying on the business, the taxpayer has completely subjected himself to them. It may be going too far to say that he must have come under an immediate obligation enforceable at law whether payable presently or at a future time. It is probably going too far to say that the obligation must be indefeasible. But it is certainly true that it is not a matter depending upon `proper commercial and accountancy practice rather than jurisprudence'. Commercial and accountancy practice may assist in ascertaining the true nature and incidence of the item as a step towards determining whether it answers the test laid down by s. 51(1) but it cannot be substituted for the test.''
His Honour also made reference to the decision of the Full Court of the Supreme Court of New South Wales in
Commissioner of Taxation (NSW) v Manufacturers Mutual Insurance Co Ltd (1931) 1 ATD 238; (1931) 31 SR (NSW) 575 where a provision similar to s 51(1) was under consideration, the case involving claims under workers' compensation insurance. The Court had said (at ATD p 240; SR (NSW) p 585):-
``In the case of the item under discussion there is no legal obligation in the sense of a cause of action immediately enforceable against the company; but from a practical business point of view, and that is the point of view from which these questions should be regarded, it is just as certain that some money will have to be paid in respect of pending claims as in respect of claims which have gone to judgment. The amount is uncertain, but apparently it is susceptible of more or less accurate estimate. Any statement of the affairs of the company professing to show the result of the year's operations, which neglected to take into account this liability, would be grossly inaccurate and misleading. In my opinion, therefore, it is an obligation standing on the same footing as an actual expenditure, which the company is entitled to deduct as a loss or outgoing actually incurred in producing the assessable income, subject of course to any necessary future adjustment.''
As reference has been made in argument to ``the matching principle'' it is appropriate to set out what his Honour took that term to mean as a result of expert evidence that had been placed before him. His Honour said (at ATC p 4181; VR p 14):-
``Further, the provision in sec. 51(1) that a loss or outgoing is an allowable deduction to the extent to which it is incurred in gaining or producing assessable income appears to me to be a statutory recognition and application of the accountancy principle which all the accountants who gave evidence referred to as the matching principle. Mr. Buckley said that this principle is almost universally accepted among Western accountants. The principle as stated by Mr. Buckley and with which the other accountants who gave evidence in substance agreed is that you endeavour as far as possible in preparing or drawing up accounts to bring to account in the same year in which you bring in revenue from a particular transaction the expenditure or anticipated losses directly related to that revenue. He further said that applying that principle he believes that it is proper and
ATC 4821necessary to bring to account by way of debit to the profit and loss account in the year in which you bring a certain premium income resulting from contracts of the kind of compulsory third party insurance estimates of the amounts likely to have to be paid out on account of claims which have been notified and also the best estimate that can be made of claims that have not yet been notified so that they will be matching the claim against the revenue. In my view not only is this in accordance with accepted accountancy principles but it is also what sec. 51(1) of the Income Tax Assessment Act contemplates.''
It appears that the appeal in RACV related to the taxpayer's first full financial year. It seems that, as a result, it was possible for it to base estimates case by case on claims files coming into existence in that year. In respect of this Menhennitt J said (at ATC p 4184; VR p 17):-
``In the result it appears to me that the taxpayer is entitled to claim a deduction in respect of the claims incurred in the year of income but not reported. The question remains as to the appropriate amount to be included. In its annual accounts the taxpayer included a statistical estimate of $1,320,000 upon the basis I have referred to. Mr. Sawkins the actuary said that in his opinion this was a reasonable estimate in the circumstances of the taxpayer at that time. By the time it lodged its return the taxpayer had made estimates case by case of the claims by then reported and arising out of events happening in the year ended 28 February 1971 and this is the amount it claimed in its return, namely, $1,420,424. I am satisfied on the evidence that this amount represented the total of reasonable estimates of the taxpayer's liability in respect of claims of which it in fact had notice by that date.''
His Honour also said (at ATC p 4184; VR pp 17-18):-
``I have referred to the fact the annual accounts of insurance companies including the taxpayer bring into account year by year the revised estimates of claims which are still outstanding. I have also referred to the justification for making an adjustment of the original estimate in the accounts of the year in which the claim is finalised. Whether it is justifiable to bring these revised estimates into account in the intervening years before the claim is finalised is a matter which does not arise for decision on this appeal (which relates only to the taxpayer's first full financial year) and accordingly I say nothing about it one way or the other.''
It may be noted that no suggestion, apparently, was raised that the appropriate level of deduction was a figure representing the present value of a sum estimated to be paid in the future in respect of outstanding liabilities. His Honour took the view that both accounting practice and the structure of the legislation required that the amount of the deduction should be arrived at by totalling the estimates of the amounts to be paid in the future in respect of the outstanding claims. Inaccuracies in these estimates should be adjusted upwards or downwards as the case may be in the income years in which the respective claims were met, the resulting figure either being an item of income or a deduction in that year. It is clear then that the question of quantification was a matter before his Honour but it was considered by him in circumstances where, apparently, no submission had been made that a ``present value'' or ``inflated-discounted'' figure should be used.
In Commercial Union Newton J followed RACV. The taxpayer, an insurance company, had appealed against its assessments of income tax for the years ended 30 June 1973 and 30 June 1974. It had claimed deductions under s 51(1) of the Act in respect of claims incurred but not reported. One of the issues raised by the Commissioner was as to the propriety of including in the amount claimed in this regard, in respect of the year ending 30 June 1973, amounts relating to claims arising from events occurring prior to 1 July 1972. The question left unresolved in RACV, therefore necessarily arose. His Honour held that the amount was properly included. He gave his reasons (at pp 4197-4198) as follows:-
``In my opinion it must now be accepted that the words `the assessable income' in sec. 51 mean assessable income of the taxpayer generally without regard to division into annual accounting periods: see
A.G.C. (Advances) Ltd. v. FC of T 75 ATC 4057 at pp 4063-4066; (1975) 132 C.L.R. 175 at pp. 185-189 per Barwick C.J. and at ATC pp 4070-4072; CLR pp 195-199 per Mason J. Hence, in my opinion, just as an estimated
ATC 4822provision for outstanding claims, including claims incurred but not reported, arising from insurances current in one year, is an allowable deduction under sec. 51 in calculating the insurer's taxable income for that year (see R.A.C.V. Insurance Pty Ltd v FC of T 74 ATC 4169; (1975) VR 1), so an increase in the estimate at the end of any subsequent year for any of those claims which are then still outstanding, is an allowable deduction in calculating the insurer's taxable income for that subsequent year. The increase in the estimate constitutes a new loss or outgoing which was incurred for the first time in the year when the revised estimate was made: compare Southern Railway of Peru Ltd. v. Owen [ 1957] A.C. 334 at p. 353 per Lord Radcliffe. As to estimates generally, reference may be made to the R.A.C.V. Insurance case 74 ATC at p 4177; (1974) 22 F.L.R. at p. 395 and the authorities there cited; and
Henderson v. FC of T 70 ATC 4016 at pp 4018-4019; (1970) 119 C.L.R. 612 at pp. 647-648 per Barwick C.J.
I may add that any other conclusion would give to sec. 51 an operation which would be quite out of accord with practical realities, having regard, inter alia, to inflation. The problem of course is relevant not only to provision for claims incurred but not reported, but also to provision for communicated but unpaid claims, especially claims arising out of compulsory third party insurance and workers' compensation insurance, which often are not paid, or paid in full, for some years after the event giving rise to the insurer's liability has occurred, and reasonable estimates of which may well increase throughout the intervening period. It is true that if the Commissioner's argument be correct, then in a case where an inadequate provision for outstanding claims was made in one year, the amount of the deficiency would be an allowable deduction under sec. 51 as the claims came to be paid. But if there were a substantial delay in paying the claims, then during the intervening years the insurer's taxable income would, in my opinion, be calculated on an unreal basis. For income which ought to be set aside to meet an increase in past estimates of still outstanding claims would be treated as part of the insurer's taxable income. No doubt provision for outstanding claims ought ideally to be made out of the premiums earned from the insurances out of which the claims arose. But where an original estimated provision which was deducted from those premiums is found on a later revised estimate to be insufficient, the amount of the deficiency ought to be deducted from the premiums earned in the year when the revised estimate is made, if the insurer's accounts are to give a true and fair view of the profit of the insurer for that year.
It may be observed that if I am right in the conclusion that for income tax purposes an estimated provision in one year for claims outstanding at the end of that year, including claims incurred but not reported, may be revised during following years, the result would not necessarily be that the insurer's taxable income would be reduced in those later years. For a revised estimate might be less than the original estimate, in which case the amount of the excess would be part of the insurer's taxable income in the year in which the revision was made: compare the R.A.C.V. Insurance case (supra) at ATC pp 4176-4177; (1974) 22 F.L.R. pp. 394-395.
Since the court in the R.A.C.V. Insurance case (supra) was concerned only with the taxpayer's first full year, the problem raised by the Commissioner's third argument did not arise for decision, although it was referred to in the judgment: see ATC at pp 4184-4185; (1974) 22 F.L.R. at pp. 406-407.''
It is plain from the evidence in this case that the applicants have followed this system of accounting for the purpose of claiming deductions year by year in respect of claims incurred but not reported as well as claims reported but unpaid at the end of the relevant fiscal year.
It must be noted, however, that the question whether a discounting process should have been undertaken for the purpose of arriving at the present value of the amounts allowed was mentioned by his Honour but not decided. He said this (at p 4198):-
``... I wish expressly to state that it was not suggested by counsel for the Commissioner that the calculation of the sum of $5,864,866 was incorrect, because no allowance was
ATC 4823made for a discount for future payment: compare Southern Railway of Peru Ltd. v. Owen  A.C. 334. Indeed no such allowance was made in the estimate of $54,155,259 in respect of communicated claims against the Commercial Union pool which were unpaid as at 30th June, 1973, although some of those claims could reasonably be expected not to be settled for a considerable time. However, since, as earlier stated, there was an overall underestimate of outstanding claims against the pool at as 30th June, 1973 (including both communicated claims and claims incurred but not reported) by an amount of more than two million dollars, it appears to me that this question is not of practical importance in the present case.''
The Commissioner places reliance upon this passage. I shall return to it later. It may be noted that his Honour made a similar remark (at p 4200) in respect of the year ending 30 June 1974.
It is the applicants' contention that the concerns raised by Newton J were not soundly based insofar as it would not be appropriate, in any circumstances, to calculate the relevant deduction in relation to these unreported and unpaid claims on the basis of ascertaining a figure for their present value at the end of the fiscal year in which the claim was made. It is submitted that authority in relation to the interpretation of s 51(1) of the Act is contrary to this view and in favour of the proposition that the appropriate figures to be taken are those which represent the nominal, payout or inflated values of the claims. It is necessary, therefore, to consider the main authorities upon which the applicants rely.
As to the basic scheme of the Act being that taxable income is calculated by deducting allowable deductions from assessable income, reference was made to the well-known authorities of James Flood at ATD p 244; CLR p 506;
J Rowe & Son Pty Ltd v FC of T 71 ATC 4157; (1970-1971) 124 CLR 421 per Menzies J at ATC p 4160; CLR p 451 and
Nilsen Development Laboratories Pty Ltd & Ors v FC of T 81 ATC 4031; (1980-1981) 144 CLR 616 per Gibbs J at ATC p 4037; CLR p 628.
In James Flood the High Court contrasted the working of the Act with the situation obtaining under English income tax law which was directed to the ascertainment of ``profits'' of the taxpayer in the relevant fiscal year. The High Court (Dixon CJ, Webb, Fullagar, Kitto and Taylor JJ) stated the difference between the two approaches as follows (at ATD pp 243-244; CLR pp 506-507):-
``The principle of the Commonwealth Act, on the other hand, is to calculate the taxable income as the amount remaining after deducting from the assessable income all allowable deductions and to restrict allowable deductions to deductions allowable under the Act. What losses and outgoings arising in the course of business are to be deducted is a matter which must be governed by s. 51(1) of the Income Tax Assessment Act. Under its provisions all losses and outgoings may be deducted 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, provided, of course, they are not of a capital nature or otherwise excluded. The word `outgoing' might suggest that there must be an actual disbursement. But partly because such an interpretation would produce very strange and anomalous results, and partly because of the use of the word `incurred', the provision has been interpreted to cover outgoings to which the taxpayer is definitively committed in the year of income although there has been no actual disbursement.
Inland Revenue Commissioners v James Spencer & Co. (1950) S.L.T. 266 at p. 268; (1950) S.C. 345 at p. 352, Lord Cooper says that from an examination of the numerous cases `the broad working rule which emerges as a guide to the crediting or debiting in a tax computation of subsequently maturing credits or debits is to inquire in which accounting period the right or liability was established, and to carry the item into the account in that year. I use the vague word ``established'' advisedly, for we are now in the region of proper commercial and accountancy practice rather than of systematic jurisprudence.' This passage must be qualified in its application under the Commonwealth Act. For under our law the facts must satisfy the expression `losses and outgoings incurred'. These words perhaps are but little more precise than the word `established' or the expression used above
ATC 4824`definitively committed'. But they do not admit of the deduction of charges unless, in the course of gaining or producing the assessable income or carrying on the business, the taxpayer has completely subjected himself to them. It may be going too far to say that he must have come under an immediate obligation enforceable at law whether payable presently or at a future time. It is probably going too far to say that the obligation must be indefeasible. But it is certainly true that it is not a matter depending upon `proper commercial and accountancy practice rather than juris- prudence'. Commercial and accountancy practice may assist in ascertaining the true nature and incidence of the item as a step towards determining whether it answers the test laid down by s. 51(1) but it cannot be substituted for the test.
To repeat what has been said before in relation to an analogous provision in the Act of 1922-1934: `To come within that provision there must be a loss or outgoing actually incurred. ``Incurred'' does not mean only defrayed, discharged, or borne, but rather it includes encountered, run into, or fallen upon. It is unsafe to attempt exhaustive definitions of a conception intended to have such a various or multifarious application. But it does not include a loss or expenditure which is no more than impending, threatened, or expected': New Zealand Flax Investments Ltd. v. Federal Commissioner of Taxation (1938) 61 C.L.R. 179 at p. 207; 5 ATD 36.''
Menzies J in Rowe (at ATC p 4160; CLR p 451) put the matter thus:-
``It seems to me, however, that the basic scheme of the Act is that taxable income is calculated by deducting allowable deductions from assessable income. It is only when it is expressly authorised that outgoings are taken into account in determining what is to be included in assessable income. An instance where a procedure of this sort is expressly required is sec. 26(a) of the Act where it is provided that a calculated profit is to be treated as assessable income. In my opinion, however, the fundamental scheme of the Act is inconsistent with attempts to calculate the profit element in each transaction undertaken by a taxpayer in the course of its business and to aggregate those profits to arrive at taxable income, or, at something which is neither taxable income nor assessable income, but is a sum from which further deductions would have to be made to arrive at taxable income.''
In Nilsen Development Gibbs J had occasion to consider
Southern Railway of Peru Ltd v Owen  AC 334, the case to which Newton J made reference in the passage cited above from Commercial Union. Gibbs J put it aside, for the purpose of Australian taxation law, in the following passage (at ATC p 4037; CLR p 628):-
``We were referred to the decision of the House of Lords in Southern Railway of Peru Ltd. v. Owen (Inspector of Taxes) (1957) A.C. 334, where it was held that the taxpayer was entitled to charge against each year's receipts the cost of making provision for the retirement payments which would ultimately be payable to its employees, as it had the benefit of the employees' services during that year, provided the present value of the future payments could be fairly estimated. This decision may be explained by the fact that under the English legislation it is necessary to compute the profits or gains of the taxpayer in the year in question. To enable the true profit to be determined it is necessary to deduct from receipts any sum which is an essential charge against those receipts. In deciding how the profits are to be ascertained the courts have regard to ordinary commercial principles. Under the Australian legislation, however, the question what losses and outgoings arising in the course of a business are to be deducted is a matter which is covered by sec. 51(1) and depends, inter alia, on the question whether the loss or outgoing has been `incurred'. The difference between the English and the Australian legislation in this regard was explained in
FC of T v. James Flood Pty. Ltd. (1953) 88 C.L.R. 492, at pp. 505-506.''
In the same case, Mason J referred with approval to the judgment in RACV. He said (at ATC p 4039; CLR p 632):-
``... There, Menhennitt J. held that the taxpayer, an insurance company, was entitled to deduct as a loss or outgoing under sec. 51 an amount reasonably estimated to be the total amount which it would have to pay in respect of its liability to indemnify
ATC 4825insured drivers against claims by third parties incurred, but not reported, during the year of income. The estimate was made in respect of accidents occurring in that year which gave rise to liability under policies then in existence.''
These statements are relied upon by the applicants. It is submitted on their behalf that the Commissioner in the present case, by seeking to confine the allowable deductions in respect of the claims in question to the amounts actually set aside by the applicants in the relevant fiscal years is, in effect, following the approach of English tax law in seeking to arrive at a relevant ``profit'' rather than following the course prescribed by s 51(1). The ``earmarked'' amounts are relevantly to be regarded as ``outgoings'' of the type referred to by Menzies J in Rowe, being amounts entering into the calculation of ``profit''. What is actually ``incurred'' is the full amount to be paid in the future in discharge of the claim.
It is submitted by the applicants that in calculating the amount of any deduction under s 51(1), regard is always paid to the ``nominal'' or ``payout'' amount of the claim even when the payment is to take place at some considerable time in the future. Regard has never been paid to the ``present value'' of the claim. This applies, it is submitted, in Australian taxation law not only in respect of obligations to pay money but also in respect of rights to receive payment, at least whenever an ``accruals'' basis of taxation accounting is appropriate in arriving at a taxpayer's assessable income. The applicants make reference to decided cases in support of these propositions.
Reliance is placed upon the often referred to passage from the judgment of the High Court in
FC of T v The Myer Emporium Ltd 87 ATC 4363 at pp 4370-4371; (1986-1987) 163 CLR 199 at pp 216-217 where the Court referred to accounting under the Act in the following terms:-
``The accounting basis which has been employed in calculating profits and losses for the purposes of the Act is historical cost (
McRae v. FC of T (1969) 121 C.L.R. 266 and see
Lowe v. Commr of IR (NZ) (1983) 15 A.T.R. 102) not economic equivalence (
Commr of IR (NZ) v. Europa Oil (N.Z.) Ltd. 70 ATC 6012; (1971) A.C. 760 at p. 772). And so a taxpayer who lends money for a stipulated period at interest is treated as exchanging the money lent for a debt of the same amount, unless the loan is made at a discount or premium, in which case there may be a gain or loss on capital account:
Lomax (H.M. Inspector of Taxes) v. Peter Dixon & Co. Ltd. (1943) 2 All E.R. 255. In the ordinary case, the debt is brought to account in the same amount as the money lent. The amount of the debt is not reduced because the lender is kept out of the use and enjoyment of the money lent for the period of the loan.
If economic equivalence were the appropriate accounting basis, the debt would be brought to account at the beginning of the period in an amount less than the amount of the money lent and would increase day by day until it equalled the amount of the money lent when the period expired.''
FC of T v Orica Limited (formerly ICI Australia Limited) 98 ATC 4494 at pp 4504, 4512.)
The use of ``nominal'' or ``face'' values received careful consideration by a Full Court of this Court in
Burrill v FC of T 96 ATC 4629; (1996) 67 FCR 519. It is necessary to make brief reference to the facts of the case. The applicant had been a deposit holder in the failed Pyramid Building Society which was wound up on 13 December 1990. In January 1991 the Government of the State of Victoria issued to the applicant Government Bonds to cover 75 per cent of his lost deposit in the Society, the Bonds guaranteeing repayment of this 75 per cent over four years. The face value of the Bonds was higher than their market value at the date of issue. The applicant claimed that the difference between the face value and the market value was an allowable deduction under s 70B of the Income Tax Assessment Act 1936 (Cth). The respondent, having disallowed the deduction, and the applicant having appealed to the Administrative Appeals Tribunal, the matter came before the Full Court as a result of a case stated by the Administrative Appeals Tribunal which included the question ``Is the applicant's loss for that year of income in respect of the accounts to be calculated pursuant to s 70B having regard to the face value of the bonds or their market value as at the date of their issue?''.
In the course of determining the matter the Court made the following statement of principle (at ATC p 4632; FCR p 523):-
``It is a fundamental principle of Australian income tax law that rights to receive money and obligations to pay money are taken into account in calculating income and outgoings, gains and losses, at their nominal value.''
After referring to the passage from Myer Emporium cited above, their Honours continued [ ATC pp 4633-4634; FCR pp 524-525]:-
``The accruals system of accounting proceeds from the basis that in calculating gains and losses it is the nominal value of money obligations that is taken into account. An accruals taxpayer brings to account an amount `earned' even though it may not be payable for some time. The amount brought to account as income is the nominal value of the amount earned at the time of derivation, and not the then value to the taxpayer of the right to receive that amount in the future. Thus in
Commissioner of Taxes (SA) v Executor Trustee and Agency Co of South Australia Ltd (1938) 5 ATD 98, at p 132; (1938) 63 CLR 108, at p 155 Dixon J, referring to
Commissioner of Taxation (Cth) v Thorogood (1927) 40 CLR 454 (where the question was whether, in a business of buying land and selling it in subdivision on instalment contracts, future instalments of purchase money should be taken into the account of taxable income derived during the accounting period), said that the court `pronounced decisively against the inclusion of the present value of these future payments'. And when, in
Henderson v FC of T 70 ATC 4016, at p 4020; (1970) 119 CLR 612, at pp 650-651, Barwick CJ, with whom the other members of the Court agreed, said that the fees of an accounting practice which had matured into recoverable debts, though unpaid, should be included as earnings, there was no suggestion that the fees were to be included at anything other than their nominal or face value. See also
J Rowe & Son Pty Ltd v FC of T 71 ATC 4157, at pp 4158-4159; (1970-1971) 124 CLR 421, at 448-449.
Another consequence of the accruals system of accounting is that income is brought to account at the nominal amount even when the money is received before derivation. A taxpayer who receives a prepayment of professional fees is not required to bring to tax a greater sum than their nominal amount even though, as a prepayment, it will have a greater value at the time of subsequent derivation than if it had been paid at that time. Thus the fees paid in advance in
Arthur Murray (NSW) Pty Ltd v FC of T (1965) 14 ATD 98; (1965) 114 CLR 314, which were not derived until the dancing lessons were given, would thereupon become part of the assessable income at their nominal amount even though paid in advance.
That is the profit, gain or income side of the coin. The other side is governed by the same principle. An accruals taxpayer brings to account a loss or outgoing incurred (s 51) even though it may not be defrayed, discharged or borne for some time. The amount brought to account is the nominal value of the loss or outgoing at the time it is incurred, and not its actual value at that time. In other words, the taxpayer does not suffer a reduction in the amount of a deduction otherwise allowable by reason that the present value of the loss or outgoing at the moment it is incurred is less than the nominal amount of the money required to discharge it sometime in the future. An obligation to pay $100 in six months time is less onerous to the taxpayer than an obligation to pay that amount forthwith. Yet in both cases the deduction allowed is for the full $100. Cf New Zealand Flax Investments Ltd v FC of T (1938) 5 ATD 36, at pp 49-50; (1938) 61 CLR 179, at p 207 and FC of T v James Flood Pty Ltd (1953) 10 ATD 240, at pp 244-245; (1953) 88 CLR 492, at p 507.
Coles Myer Finance Limited v FC of T 93 ATC 4214; (1993) 176 CLR 640 is instructive in this connection. A finance company drew short term bills of exchange, procured their acceptance by a bank, and sold them at a discounted price. On maturity the bills were paid out at face value. Several bills were outstanding at the end of the tax year in which they had been drawn. It was held that the discounted amounts referable to them were losses or outgoings incurred by the taxpayer in that year within s 51(1). The discount amounts were the cost of obtaining the finance. What is important for present
ATC 4827purposes is that a doctrine of economic equivalence would have denied the taxpayer any deduction, because the amounts it received on the sale of the bills were the true value, at the dates of sale, of the amounts it was required to pay upon their maturity.''
The question in Burrill was consequently answered ``[a]ccording to the face value''.
Prima facie, in my view, unless Burrill can be distinguished, it governs the outcome of the present case. It is the future payout figure, being the ``inflated'' figure which constitutes the deduction to be allowed to the applicants. The restriction of the deduction to the ``present value'' of that figure or an ``inflated and discounted'' figure would run counter to the approach approved in Burrill. Moreover, as I have already indicated, it would run counter to the interpretation of s 51(1) which has been adopted in the cases referred to above, which is productive of a system of tax accounting different from that required by English taxation legislation. Furthermore, the use of nominal rather than present value figures is taken into account in and, indeed, forms the basis of adjustments in successive fiscal years, in the accounting procedures referred to and sanctioned by RACV and Commercial Union. The use of inflated and discounted figures in those procedures would appear to render them unworkable.
It is necessary, then, to consider whether the arguments adduced by the respondent in this case are productive of a different result. I turn to them now.
The respondent's case
In the first place, the Commissioner seeks to distinguish Myer Emporium and Burrill. It is submitted that in each of those cases the nominal or face value was fixed and determined by the terms of the instruments in question. The situation, it was put, was very different in the present case where the claimed deduction was only an actuarially estimated amount being the calculated total figure to be paid to discharge the claims in the future. Furthermore, it was an amount to be paid by way of indemnity to the insured policy holder in respect of its liability to a third party and not in respect of a direct financial obligation of the taxpayer.
I reject this submission. It asserts a distinction without a difference. The figure arrived at by actuarial estimate was a figure used to establish the amount of a future payment. It did not differ relevantly from the figures established by the instruments in Myer Emporium and Burrill as amounts payable in the future. Each figure represented the total amount necessary to discharge a future obligation. Each was an undiscounted figure. Each ignored that, as a matter of prudent commercial practice, the payer would set aside some amount, less than the ultimately payable total figure, so that it might accrue, with interest, to a sum sufficient to discharge the future obligation. It was not suggested that actuarial calculation and estimation was not an available and appropriate method for arriving at such a final figure. It clearly was. Such an estimated figure can be accepted as an ``incurred'' outgoing pursuant to s 51(1) (see eg
Australia and New Zealand Banking Group Ltd v FC of T 94 ATC 4026 at p 4035; (1994) 48 FCR 268 at pp 280-281). It is nothing to the point that the payment is made to discharge a contractual obligation to indemnify rather than to meet a direct financial commitment.
The Commissioner also contends that the applicants' use of the ``inflated'' figure instead of the ``present value'' figure leads to a distortion of ``the matching principle''. This submission is based upon the evidence of expert witnesses called for the respondent, Professor Peirson and Mr Buchanan. Each witness was expert in the field of commercial accounting but each made it clear that he claimed no expertise in the field of taxation. As I understand their evidence, they merely emphasised what was in fact conceded by the applicants, namely that for the purpose of internal accounting and commercial management it was necessary, on an annual basis, to set aside and invest an amount of money calculated to be sufficient to provide for the payment in the future of claims ``incurred'' in that fiscal year. The figure was arrived at by discounting from the inflated figure, which had been calculated for the purpose of estimating the amount necessary to discharge the ``incurred'' liabilities when the time came for their payment. Indeed, Mr Buchanan stated ``[t]he purpose of discounting is to determine the value of the assets needed now to provide for the (inflated but undiscounted) projected future payments''. The applicants, clearly, do not quarrel with this statement nor, indeed, with a corresponding statement from Professor Peirson that ``[i]n my
ATC 4828opinion inflating and discounting are necessary elements of the process of determining an appropriate provision for long-tail insurance claims...''.
However, the Commissioner relies upon a further proposition of Professor Peirson to the effect that the procedure followed by the applicants distorts ``the matching principle'' by giving ``an incorrect measure of the liability for outstanding claims and, therefore, an incorrect measure of the claim's expense. In turn, this will give an incorrect measure of profit by overstating the expenses and understating the profit''.
The concept of ``the matching principle'' is to be found in the passage from RACV cited above, in which Menhennitt J referred to s 51(1) as being its ``statutory recognition''. The approach of Menhennitt J was approved by the High Court in
Coles Myer Finance Limited v FC of T 93 ATC 4214 at p 4222; (1993) 176 CLR 640 at pp 665-666. I have great difficulty in understanding how it can be asserted that the applicants' ascertainment of the deductions to be made for outstanding claims liabilities in a fiscal year can transgress the matching principle enunciated by Menhennitt J when the procedures which were the subject of explanation and approval in that case appear to have been followed. In my opinion, there has been no violation of any matching principle when that principle is understood as a jurisprudential rather than a commercial postulate. So understood, what must be matched is the premium component of the assessable income of the year in question and the amounts which must be paid in the future to satisfy claims the risk of which is covered by the insurance purchased by those premiums. The payments required to discharge the liabilities arising from those claims will necessarily be made in the future. They will be made in the money value of the day of payment and will accord with the levels of compensation appropriate to that time. The discounted amounts contemplated by Professor Peirson and Mr Buchanan are not moneys paid out to indemnify policy holders in respect of claims made against them, against the risk of which they have obtained cover by the payment of the premiums. They are amounts invested for the purpose of the later meeting of those claims. The income from such investments will itself form part of the applicants' assessable income and, as such, be liable to tax. They do not answer the description of ``outgoings incurred'' in s 51(1).
A closely related submission was made by the Commissioner, namely that to deduct the inflated figure was to transgress a requirement that the applicants were only entitled to deduct so much of the liability as was truly referable to the period in which the liability was incurred. Taking the inflated figure as the deduction was to include amounts which must necessarily be related to monetary inflation in the years following the fiscal year in question, with a consequent failure to match against the premiums of that year liabilities which related to that year alone. Reliance was placed upon a passage in Coles Myer at ATC p 4222; CLR p 665.
I am satisfied that Coles Myer does not assist the Commissioner in the present case, although there are statements in the judgment of the majority (Mason CJ, Brennan, Dawson and Toohey and Gaudron JJ) which, at first sight, might appear to do so. Thus, in the majority judgment (at ATC p 4221; CLR p 663) the following passage appears:-
``But it is not enough to establish the existence of a loss or outgoing actually incurred. It must be a loss or outgoing of a revenue character and it must be properly referable to the year of income in question... So it was that in New Zealand Flax the taxpayer was not entitled to deduct all payments of interest in future years notwithstanding that it had incurred a liability to pay them in the accounting period under assessment.''
The reference to New Zealand Flax is to the case of
New Zealand Flax Investments Ltd v FC of T (1938) 5 ATD 36; (1938) 61 CLR 179 where the following passage appears in the judgment of Dixon J (at ATD p 50; CLR p 208):-
``In my opinion the most satisfactory way of dealing with the appeal is to set aside the assessments and to remit them to the Commissioner for re-assessment, so as to enable him to include only bond moneys received in the accounting periods and to allow whatever part, if any, of the deductions claimed for future interest and deferred commission appears referable to the accounting periods under assessment.''
It is clear, however, that neither Coles Myer nor New Zealand Flax are authority for any broad principle to the effect that any payment of moneys in the future claimed as a deduction in a year of income must be subject to some form of proportionate reduction having regard to the years that may elapse from the fiscal year in question to the year of payment. Even if this were so, it would not necessarily follow that the adoption of present value accounting would achieve this purpose.
The scope and effect of the Coles Myer decision was the subject of consideration by a Full Court of this Court in
FC of T v Woolcombers (WA) Pty Ltd 93 ATC 5170; (1993) 47 FCR 561 where the facts of the case were summarised (at ATC p 5178; FCR p 572) as follows:-
``In Coles Myer, the taxpayer, acting as a financier to a group of companies, during the year ended 30 June 1984, drew and sold, at less than face value, bills and promissory notes, a significant proportion of which were outstanding at 30 June 1984. In its return for that year, the taxpayer claimed a deduction for the difference between the face value and the sale price. The Commissioner disallowed the claim on the footing that no loss or expenditure was incurred until the instruments were paid out in the next year. It was held by the majority (Mason CJ, Brennan, Deane, Dawson, Toohey and Gaudron JJ) that the total cost should be apportioned; and that, having regard to the relatively short life of the bills and notes, apportionment on an accounting straight line basis was appropriate....''
It was submitted in argument in Woolcombers that Coles Myer dealt with an unusual situation in which a deduction was sought for a net loss or outgoing not the gross amount. It was also put that the decision ``did not overrule, sub silentio, the long line of authority which establishes that `the assessable income' in s 51(1) means assessable income of the taxpayer generally without division into accounting periods''. A further submission was put which was summarised in the judgment (at ATC p 5177; FCR pp 569-570) as follows:-
``... The cases relied upon by the Commissioner for the `timing' principle were said all to have involved a deduction for interest or an amount in the nature thereof. Those cases do not lay down an additional requirement for deductibility of all outgoings. Interest is in a special category in that liability for it accrues on a daily basis. The Commissioner's sub- missions were said to be no more than an attempt to substitute some sort of `matching principle' for the statutory criterion. The question could not be answered by asking when accountants would treat the outgoing as an `expense'.''
These submissions were basically accepted by the Court when it said (at ATC 5181; FCR pp 575-576):-
``As has been said, the complexity of the scheme in New Zealand Flax called for an inquiry of the kind there ordered. In our opinion, there is no such complexity here. In Coles Myer, because of the special nature of the financing transaction, it was held, by the majority, that apportionment was appropriate. Likewise, in the financial arrangements considered in Australian Guarantee, apportionment of the total sum of the interest was proper. But there are no similar features in the present matter, which concerns a relatively simple forward contract for sale without any financing aspect; no question arises here of a liability accruing daily, as interest does, or otherwise accruing periodically.''
In my opinion, the same reasoning applies in the present case. The actuarially estimated amount for the payment of the relevant claims in the future does not involve any concept of liability accruing daily or periodically, nor is there any special complex financing transaction involved. I am satisfied that Coles Myer does not require that the Commissioner's submission be accepted.
Reliance was also placed by the Commissioner on the passages from Commercial Union set out above, in which Newton J raised the possibility of deductions being calculated on a present value basis. As I have already indicated, it is my view that such an approach cannot be adopted in light of the decision in Burrill and in the other cases to which reference has been made. However, further support for this approach was sought in a passage from the judgment of Deane J in Coles Myer at ATC p 4226; CLR pp 672-673. This passage might be read as providing support for the proposition that the appropriate deduction to be made in the present case was
ATC 4830one made on a present value basis. The passage is obiter. The circumstances envisaged in the hypothetical example given are remote from considerations relating to outstanding claims in the insurance industry. I am far from persuaded that the passage, when read as a whole, really supports the Commissioner's main proposition in the present case. In any event, it appears to find no support in the other judgments in Coles Myer and does not, in my respectful view, affect the authority of Burrill.
Moreover, I am in agreement with the thrust of the applicants' submissions that to adopt the present value approach would be to depart from the orthodox interpretation of s 51(1) and to adopt the approach of the English cases, where the focus of the inquiry is on ``profit'' of the taxpayer in the relevant year (see e.g. Southern Railways of Peru Limited v Owen at pp 358-361;
Gallagher v Jones (Inspector of Taxes)  Ch 107 at p 134;
Johnston (HM Inspector of Taxes) v Britannia Airways Ltd (1994) BTC 298 at pp 312-316). Indeed, the passage cited above from the evidence of Professor Peirson indicates, to my mind, that, in his reference to ``profit'', he was adopting this approach. Also the reference to Owen in IT 2663 indicates that the Commissioner has done the same. Indeed, the Commissioner relies on these cases in his submissions. The fundamental difference between the approaches was referred to in the judgment of the Privy Council in
C of IR v Mitsubishi Motors New Zealand Ltd 95 ATC 4711, an appeal from the New Zealand Court of Appeal. The relevant provision in the New Zealand Income Tax Act 1976 was in almost the same terms as s 51(1), with the result that Australian decisions on the meaning of the word ``incurred'' were in point. Lord Hoffman made the following comment (at p 4714):-
``The second point is that the question of whether the expenditure has been `incurred' involves characterising the nature of the legal relationship between the taxpayer and the person to whom the obligation is owed. On one view, it requires one to decide as a matter of construction whether the obligation is contingent or vested but defeasible. This is a nice distinction which can easily become a matter of language rather than substance and on which judicial views may differ; for an example, see
C of IR v Glen Eden Metal Spinners Ltd (1990) 12 NZTC 7,270. Both points illustrate the fact that this construction involves taking what the Australian courts have called a jurisprudential rather than a commercial view of the meaning of `incurred'. This is an unusual approach to a taxing statute and their Lordships detect in the Australian cases some degree of tension between loyalty to formal legal doctrine and reluctance to accept a computation of taxable profits which is wholly divorced from commercial reality.''
If such a tension exists, then it is something that a first instance judge is obliged to experience but is not permitted to resolve. I am satisfied that I am bound by the decision in Burrill to reject the Commissioner's submissions which are, in effect, based upon the approach of the English courts to English legislation.
Two further submissions were made on behalf of the Commissioner, each of which I reject. First, it was put that if I were otherwise opposed to the Commissioner's submissions I should, nevertheless, hold that it was inappropriate for the ``prudential margin'' to be included in the deduction. In my opinion, the evidence amply demonstrates that its inclusion was a proper commercial decision and one that rendered the estimate of the amount of the future liability more reliable. Indeed, according to the evidence, the relevant estimates have fallen short of the amounts actually required to provide the indemnity contracted for. Once it is accepted that the figure for deduction can be arrived at by estimation, then the inclusion of this allowance can be seen as an integral and proper step in that process.
The second submission was that the amount of the deduction should be arrived at by taking a no inflation-no discount approach. As I understand it, this was a contention that a figure should be taken which would represent the amount necessary to pay the relevant claims on the basis that they had become payable before the end of the fiscal year. It may be noted that this approach was expressly disavowed in IT 2663, it being said that it relied on the unrealistic premise that all claims were paid out at the end of a year of income. In my view, there is no basis for accepting this approach as providing a satisfactory estimate of the amount of the relevant deduction.
For these reasons, I am of the opinion, that the appeal should be upheld. In accordance with what I understand to be the wishes of the parties I remit these matters to the Commissioner for reassessment in accordance with these reasons. I order the Commissioner to pay the applicants' costs of this appeal.
THE COURT ORDERS THAT:
1. The appeal be upheld.
2. These matters be remitted to the Commissioner for reassessment in accordance with these reasons.
3. The respondent to pay the applicants' costs of this appeal.
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