Edited version of your written advice

Authorisation Number: 1012857569683

Ruling

Subject: Non-resident insurance

Question

Is the Agreement considered to be an 'insurance contract' as defined in section 141 of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No.

This ruling applies for the following periods:

Income years ended 30 June xxxx to 30 June xxxx.

The scheme commences on:

1 July xxxx

Relevant facts and circumstances

The Agreement is a tripartite agreement between:

• Entity A;

• Banks B and C

• Entity D acting as Agent for the Non-Resident Entities, and

• Non-Resident Entities.

The Agreement operates as follows:

An unrelated party (UP) requires Entity A to procure bank guarantees to secure Entity A's payment obligations to UP.

Revolving bank guarantee facilities will be made available to Entity A by Banks B and C.

If Entity A fails to pay an amount due to UP or any other beneficiary of a bank guarantee issued under the Agreement then that beneficiary can claim that amount from Banks B and C under the bank guarantees.

Banks B and C can then require payment of an amount equal to the amount paid by them under a bank guarantee under an indemnity provided to them by the Non-Resident Entities. This would be done by Banks B and C making a demand on Entity D. Entity D would, in turn, make a demand on each Non-Resident Entity. The Non-Resident Entities would then make payments to Entity D, which would then on-pay those amounts to Banks B and C.

Entity A has agreed to indemnify each Non-Resident Entity against any loss incurred by the Non-Resident Entities in complying with their obligations to make payments to Banks B and C.

If Entity A or a Non-Resident Entity fails to pay any amount payable by it on its due date, interest shall accrue on the overdue amount from the due date up to the date of actual payment.

Each of the Non-Resident Entities have represented and warranted to Entity A that it did not have any agent or representative in Australia that was in any way instrumental in inducing any other party to enter into the Agreement.

With the exception of some matters of an administrative nature, Entity D is required to exercise the rights, powers, authorities and directions given to it, and accept delivery of all notices and demands, under or in connection with the Agreement and related documents through its Office. Consistent with the Non-Resident Entities, the Office of Entity D must be located outside Australia in accordance with the definition of Office in the Agreement.

Entity A will pay to Entity D, for the account of each of the Non-Resident Entities, Fees (comprising a usage fee and an availability fee), both calculated on a percentage per annum basis.

Both components of the Fees are payable in arrears on each due date until the termination date of the Agreement.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 141

Reasons for decision

All legislative references in this 'Reasons for decision' are to the ITAA 1936 unless otherwise indicated.

Section 141 defines an insurance contract for the purposes of Division 15 of Part III as follows:

insurance contract means a contract or guarantee whereby liability is undertaken, contingent upon the happening of any specified event, to pay any money or make good any loss or damage, but does not include a contract of life assurance.

Under a strict literal interpretation of the definition of insurance contract, the potential scope of sections 141-147 could be considered extremely broad, arguably to include warranties (as the term warranty is often used interchangeably with guarantee in commercial parlance), bank guarantees and guarantees provided by a foreign parent in relation to borrowings by an Australian subsidiary (where all the remaining requirements of Division 15 of Part III are satisfied).

In Federal Commissioner of Taxation v. Cooling (1990) 22 FCR 42; 90 ATC 4472; (1990) 21 ATR 13, Hill J observed at FCR 68; ATC 4493; ATR 37 that:

…the process of statutory construction does not consist merely of ascertaining the meaning of words used aided, if necessary, by a dictionary. As Gibbs C.J. said in Cooper Brookes (Wollongong) Pty. Ltd. v. F.C. of T. 81 ATC 4292 at p. 4296; (1980-1981) 147 C.L.R. 297 at p. 304: ``Of course, no part of a statute can be considered in isolation from its context - the whole must be considered.'' It is only where the language of the statute, being seemingly clear and unambiguous is ``... consistent and harmonious with the other provisions of the enactment and can be intelligibly applied to the subject matter with which it deals'', that effect will be given to what appears to be the ordinary and grammatical meaning of the words (cf. per Gibbs C.J. at ATC p. 4296; C.L.R. p. 305).

Therefore, it falls to be considered whether the definition of insurance contract contained in section 141 should be viewed as applying to all contracts and guarantees that satisfy the remaining requirements of the definition or whether it should be read down to limit its application to 'insurance products'.

The approach of reading down the section 141 definition of insurance contract to limit its application to insurance products is clearly demonstrated in the manner in which Australia's international tax agreements seek to allow Division 15 of Part III to apply.

As an example, paragraph 4(b) of the Protocol to the Agreement between the Commonwealth of Australia and the Federal Republic of Germany for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital and to certain other Taxes, and Protocol [1975] ATS 8 (the German DTA) allows Division 15 of Part III to tax income even though the German taxpayer does not have an Australian permanent establishment in the following manner:

Article 7 of the Agreement shall not apply to profits of an enterprise from carrying on a business of any form of insurance, other than life insurance.

This exception to the Article 7 of the German DTA restriction is only effective insofar as the business being taxed by Division 15 of Part III is insurance at general law. Therefore, the words 'contract' and 'guarantee' under the section 141 definition of insurance contract must be read in this context. It is considered those terms, and in particular use of the term guarantee, was not intended to expand the scope of sections 141 to 147, but rather was to prevent any mischief. In other words, the section 141 definition was intended to catch arrangements which were, in substance, truly insurance. Therefore, in deciding whether a contract or guarantee satisfies the definition of insurance contract in section 141, general law concepts must be applied.

If the use of the term 'insurance contract' in section 141 was capable of being given a wide definition, then it would appear that the construction of Division 15 of Part III would give taxing rights over for example, non-resident bank guarantees under paragraph 4(b) of the Protocol to the German DTA.

In the event that such a wide application was sought, it is considered that paragraph 4(b) of the Protocol to the German DTA would then act to restrict the application of Division 15 of Part III to insurance at general law, and negate the extension read into the section 141 definition of 'insurance contract'.

Further, Law Administration Practice Statement PS LA 2007/8 Treatment of non-resident captive insurance arrangements states in relation to Division 15 of Part III, at paragraph 10, albeit in the context of the commerciality of captive insurance arrangements, that:

…the Division only applies to genuine insurance arrangements.

In paragraph 14 of Taxation Ruling IT 2663 Income tax: basis of assessment of general insurance activities the term 'general insurance' is defined to mean:

… a contract or guarantee under which a general insurer undertakes a liability, contingent on the happening of any specified event, to indemnify an insured for an agreed money value of any loss or damage. It does not include a contract of life assurance.

With this definition being almost identical to that of 'insurance contract' contained in section 141 further support is provided to the view that the Division was intended to capture arrangements which are, in substance, insurance.

Is the Agreement an insurance contract?

The Agreement is a tripartite agreement between Entity A, Banks B and C (which will issue the bank guarantees to creditors of Entity A) and the Non-Resident Entities which agree to pay Banks B and C for any amounts they are required to pay out under those bank guarantees.

Entity A is required to indemnify the Non-Resident Entities against any loss suffered by them as a result of Banks B and C seeking payment from them under the Agreement.

Goods and Services Tax Ruling GSTR 2006/1 Goods and services tax: guarantees and indemnities states at paragraphs 38-39:

38. A contract of insurance may be classified according to its nature, that is, whether it is one of indemnity or whether it amounts to a contract for the payment of a sum of money on the happening of a contingency.⁶ Indemnity insurance holds the insured harmless against loss. This is the object of the most commonly understood type of insurance.⁷

39. Contracts of insurance can be distinguished from guarantees and other forms of indemnity. Unlike a surety under a guarantee or indemnity covered by item 7 or 7A, an insurer has no underlying right to be indemnified by the insured. The insurer bears the full risk of the contract. For this reason, contracts of insurance are contracts uberrimae fidei - contracts of 'utmost good faith' - and are therefore conditional on the insured disclosing to the insurer facts relevant to the risk the insurer will bear. (emphasis added)

Under the Agreement, Entity A has an obligation to pay amounts to UP, and the way it is ensuring that it can make these payments when they fall due is by entering into the Agreement. The Agreement appears to expect that if Entity A does not make the payment on time to UP it will still ultimately pay the amount owing to UP, but will pay it to the Non-Resident Entities in recognition of the fact that Banks B and C, and then the Non-Resident Entities have made payments that ensure that the obligation to UP was paid on time. While each party under the Agreement has a risk that the party that is obliged to make the payment to them will not do so, this risk appears to be the type of risk that generally arises in a credit facility type arrangement rather than a contract of insurance.

Thus the Agreement may be distinguished from an insurance arrangement as generally understood, whereby the insurer bears the economic risk associated with the insured event. (although ultimately the Non-Resident Entities will bear the risk of Entity A not being able to satisfy its obligation to pay them pursuant to the Agreement).

Entity A will pay to Entity D, for the account of each of the Non-Resident Entities, Fees (comprising a usage fee and an availability fee).

Under a contract of insurance the contract is usually made in a commercial context, and the insurer receives a premium. The ITAA 1936 does not contain a definition of the term 'premium'.

ATO Interpretative Decision ATO ID 2005/98 Income tax: application of section 121 of the Income Tax Assessment Act 1936 to a mutual discretionary fund states that:

'Premium' has been defined by the courts as 'the consideration given by the insured to the insurer in return for the latter's promise to insure the risks specified in the contract'; Lewis v. Norwich Union Fire Insurance Co (1916) App D [Sth African Appellate Court] 509 at 519 (emphasis added).

The Fees paid by Entity A to Entity D, for the account of each of the Non-Resident Entities, is the consideration that the Non-Resident Entities require in order to agree to take on the obligation to make good the loss suffered by Banks B and C where a demand has been made under the terms of the Agreement. Thus the Fees are for the benefit of Banks B and C (not Entity A).

The Fees would take into account that where an amount was payable by the Non-Resident Entities, the Non-Resident Entities would then be entitled to claim the amount from Entity A. This feature of the arrangement, whereby the Non-Resident Entities can make a claim against Entity A suggests that the arrangement is more in the nature of a credit facility rather than a form of insurance.

It may be suggested that the Agreement is comparable to lenders mortgage insurance. However, under lenders mortgage insurance the insurer's policy is with the lending institution with the premium payable by the insured (that is, the lending institution), being passed on to the borrower as a one off cost of the loan (that is, as a fee). Under the Agreement the liability to pay the Fees has not been 'passed on' by Banks B and C. Further, under the Agreement, Entity A has an obligation to the Non-Resident Entities to make good their loss. While an insurer under lenders mortgage insurance could itself take out reinsurance, it would not be expected to do this with the original borrower (who would be Entity A in this case by way of analogy). Accordingly, while the Agreement has some similarities to lenders mortgage insurance, it is not considered to be an insurance arrangement of this or a similar type.

The Fees payable by Entity A can be seen broadly to consist of 2 components, both calculated on a percentage per annum basis.

Both components of the Fees are payable in arrears on each due date until the termination date of the Agreement.

As per paragraph 26 of IT 2663 '(P)remiums received by a general insurer commonly cover the 12 months' period of a policy'. Ordinarily that premium is paid upfront upon acceptance by the insured of the offer made by the insurer, or at a minimum, the first instalment is paid up front upon acceptance should the annual premium be paid monthly.

In the present circumstances, the Fees (calculated on a percentage per annum basis) are payable in arrears, presumably reflecting the fact that ultimately Entity A assumes all the risk under the Agreement. Ordinarily, a 'premium' payable under an insurance contract would be determined up front upon an appropriate assessment of the risk by the insurer. Under the Agreement the majority of Fees (that is, the usage fee) are indeterminable up front as they can only be calculated with the effluxion of time, hence the fact they are payable in arrears.

Neither of these characteristics is peculiar to an insurance contract as it is commonly understood and are more in the nature of those found in relation to a revolving credit facility. Further support for this characterisation is provided by the interest that is payable under the Agreement where an amount due for payment is overdue.

Furthermore, if Entity A or a Non-Resident Entity fails to pay any amounts payable by it on its due date, interest begins to accrue on that amount. Again, this type of condition is not typical of an insurance contract.

Conclusion

Consequently, whilst the Agreement may exhibit some elements that, in isolation, may be considered to be in the nature of insurance, taken as a whole, it is not considered to be an 'insurance contract' as defined in section 141.