Edited version of private advice

Authorisation Number: 1052329213785

Date of advice: 12 November 2024

Ruling

Subject: Life insurance companies - reinsurance - deductions and assessable income

Question 1

Will a Reinsurance Premium paid by Australian Insurer to Resident Reinsurer pursuant to the Reinsurance Treaty be deductible to Australian Insurer under section 320-100 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Where an Additional Payment is made by Resident Reinsurer to Australian Insurer pursuant to the Reinsurance Treaty, will the Additional Payment amount be included in Australian Insurer's assessable income under paragraph 320-15(1)(b) of the ITAA 1997?

Answer

Yes.

Question 3

Where an Additional Payment is made by Australian Insurer to Resident Reinsurer pursuant to the Reinsurance Treaty, will the Additional Payment amount be deductible to Australian Insurer under section 8-1 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

Years ending 31 December 20XX to 31 December 20XX

The scheme commenced on:

1 March 20XX

Relevant facts and circumstances

Australian Insurer

1.        Australian Insurer is an Australian resident company for tax purposes.

2.        Australian Insurer is registered under section 21 of the Life Insurance Act 1995 (Life Insurance Act) to write life assurance business in Australia.

3.        Australian Insurer carries on a business of providing a range of life insurance products to its customers. In the ordinary course of its business and to manage its risk profile, Australian Insurer reinsures some or all of the risk under the policies written with reinsurers.

The Insurance Policy

4.        Australian Insurer provides death, total and permanent disablement and income protection group insurance cover to members of a Superannuation Fund under policies with the Superannuation Trustee.

5.        On 1 March 20XX, Australian Insurer and the Superannuation Trustee entered into the Insurance Policy, which provides income protection insurance cover to Insured Members for Disability and Permanent Incapacity.

6.        The Insurance Policy is a 'life policy' within the meaning of section 9 of the Life Insurance Act.

7.        The Insurance Policy is not an 'exempt life insurance policy' within the meaning of section 320-246 of the ITAA 1997 or a 'funeral policy' as defined in subsection 995-1(1) of the ITAA 1997.

8.        The Insurance Policy does not provide for 'participating benefits' within the meaning of section 15 of the Life Insurance Act or 'discretionary benefits' as defined in subsection 995-1(1) of the ITAA 1997.

9.        The assets supporting the Insurance Policy are included in Australian Insurer's taxable income of the 'ordinary class' within the meaning of section 320-139 of the ITAA 1997.

10.      Under the Insurance Policy, Australian Insurer will pay Superannuation Trustee an Income Protection benefit if an Insured Member is Disabled or Permanently Incapacitated after the end of the relevant waiting period.

11.      The Insurance Policy includes a description of the specified set of circumstances relating to the nature and extent of the condition of the Insured Member which must be satisfied in order for either a Disability benefit or a Permanent Incapacity benefit to be payable.

Resident Reinsurer

12.      Resident Reinsurer is an Australian resident company for tax purposes.

13.      Resident Reinsurer is registered under section 21 of the Life Insurance Act to write life reinsurance business in Australia.

The Reinsurance Treaty

14.      Australian Insurer entered into the Reinsurance Treaty with Resident Reinsurer to reinsure part of the risk insured by Australian Insurer under the Insurance Policy and other group insurance policies written by Australian Insurer. The Reinsurance Treaty commenced on 1 March 20XX (the Effective Date).

15.      The Reinsurance Treaty provides that Australian Insurer agrees to cede and Resident Reinsurer agrees to accept the cession of the insurance policies falling within the scope of the Reinsurance Treaty.

16.      Australian Insurer and Resident Reinsurer executed an amendment to the Reinsurance Treaty (the Amendment), which took effect from the Effective Date. The Amendment had the effect of modifying the Reinsurance Treaty in respect of a portion of the risk under the Insurance Policy.

17.      Australian Insurer entered into the Amendment to better manage its counterparty exposures and regulatory capital requirements.

18.      The Amendment specifies the insurance policies covered under the Reinsurance Treaty and provides that the Reinsurance Treaty applies to cover for Disability and Permanent Incapacity under the Insurance Policy (the Business Covered).

19.      The Amendment specifies that, in respect of the Business Covered, Australian Insurer shall retain XX% of the risk and Resident Reinsurer shall be liable for the remaining XX% of the risk.

20.      The Australian Prudential Regulation Authority has recognised that the Reinsurance Treaty, as amended by the Amendment, results in a genuine transfer of insurance risk from Australian Insurer to Resident Reinsurer.

Reinsurance Premium

21.      The Amendment provides that Australian Insurer will pay Resident Reinsurer a monthly premium in respect of the Business Covered under the Reinsurance Treaty (Reinsurance Premium).

22.      The Reinsurance Premium is calculated based on the Gross Premium earned by Australian Insurer in respect of the Business Covered under the Insurance Policy, multiplied by an agreed reinsurance margin.

Additional Payment

23.      The Amendment also provides for a process (known as the Additional Payment) under which any variance from the agreed expected claims outcome in relation to the Business Covered (the Estimated Claims) for a particular Calculation Period is settled between Australian Insurer and Resident Reinsurer.

24.      The Estimated Claims are determined based on the Gross Premiums earned by Australian Insurer under the Insurance Policy from the Effective Date to the relevant Calculation Date, multiplied by an agreed Claims Percentage.

25.      The Additional Payment is determined based on any variance between the Estimated Claims and the actual claim payments made under the Insurance Policy from the Effective Date to the relevant Calculation Date, plus an estimate of the expected remaining payments for claims incurred for that period (the Current Claims), with any previous payments made under the Additional Payment process subtracted to adjust for previous Calculation Periods.

26.      The Additional Payment process is undertaken on a periodic basis at the relevant Calculation Date specified in the Amendment.

27.      In accordance with the terms of the Amendment:

a.      if the Additional Payment amount is determined to be zero, no Additional Payment will be made under the Reinsurance Treaty;

b.      if the Additional Payment is determined to be a positive amount, Australian Insurer must pay the Additional Payment amount to Resident Reinsurer by the relevant Payment Date; and

c.      if the Additional Payment is determined to be a negative amount, Resident Reinsurer must pay the Additional Payment amount to Australian Insurer by the relevant Payment Date.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 148(1)

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 paragraph 320-15(1)(b)

Income Tax Assessment Act 1997 section 320-80

Income Tax Assessment Act 1997 section 320-100

Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision

All legislative references in these reasons for decision are to the ITAA 1997, unless otherwise stated.

Question 1

Will a Reinsurance Premium paid by Australian Insurer to Resident Reinsurer pursuant to the Reinsurance Treaty be deductible to Australian Insurer under section 320-100?

Summary

As a Reinsurance Premium is an amount that is paid by Australian Insurer to Resident Reinsurer as a 'life insurance premium' under a 'contract of reinsurance' and does not relate to a risk (or part of a risk) in relation to which subsection 148(1) of the Income Tax Assessment Act 1936 (ITAA 1936) applies, the Reinsurance Premium will be deductible to Australian Insurer under section 320-100.

Detailed reasoning

Section 320-100

1.    The ITAA 1997 categorises deductions as 'general deductions' and 'specific deductions'. General deductions are those amounts which can be deducted under section 8-1. Specific deductions are those amounts which are allowed as a deduction under a specific provision (section 8-5).

2.    Subdivision 320-C specifies deductions that are available to a life insurance company, including under section 320-100 (section 320-50).

3.    Section 320-100 provides that a 'life insurance company' can deduct amounts that:

(a)  were paid by the company in the income year as *life insurance premiums under *contracts of reinsurance; and

(b)  do not relate to a risk, or part of a risk, in relation to which subsection 148(1) of the Income Tax Assessment Act 1936 applies.

4.    Australian Insurer is a 'life insurance company' within the meaning of subsection 995-1(1), as it is a company registered under section 21 of the Life Insurance Act.

Contract of reinsurance

5.    Taxation Ruling TR 95/5 Income tax: basis of assessment of reinsurance activities (TR 95/5) states (at paragraphs 1 and 33) that, in general, reinsurance is the insuring of the risks undertaken by an insurer. Reinsurance is a form of insurance and many of the principles and practices applying to the conduct of insurance business generally apply equally to reinsurance.

6.    Subsection 995-1(1) does not provide an exhaustive definition of the term 'contract of reinsurance'. Rather, the definition of 'contract of reinsurance' in subsection 995-1(1) states that a:

contract of reinsurance, in respect of *life insurance policies, does not include a contract of reinsurance in respect of:

(a)    the parts of *complying superannuation life insurance policies in respect of which the liabilities of the company that issued the policies are to be discharged out of a *complying superannuation asset pool; or

(b)    policies that are *exempt life insurance policies.

7.    Based on this definition, a 'contract of reinsurance' must reinsure a 'life insurance policy'. Under subsection 995-1(1), 'life insurance policy' has the meaning given to the expression 'life policy' in section 9 of the Life Insurance Act. For completeness, a 'life insurance policy' under subsection 995-1(1) also explicitly includes a contract made in the course of carrying on business that is 'life insurance business' because of a declaration in force under section 12A or 12B of the Life Insurance Act, and a sinking fund policy within the meaning of the Life Insurance Act.

8.    As the Insurance Policy is a 'life policy' under section 9 of the Life Insurance Act, it is a 'life insurance policy' within the meaning of subsection 995-1(1) (and for the purposes of the definition of a 'contract of reinsurance').

9.    Apart from this requirement and the explicit exclusions in paragraphs (a) and (b) of the definition, the term 'contract of reinsurance' may be interpreted in accordance with its ordinary meaning, subject to the context in which it appears, for the purposes of subsection 995-1(1).

10.  In TR 95/5, the Commissioner describes a contract of reinsurance as follows:

34. A contract of reinsurance has also been described as an independent contract of insurance. (Barker J in Farmers Mutual Insurance Ltd v. QBE Insurance International Ltd; American International Underwriters Ltd v. Farmers Mutual Insurance Ltd (1993) 7 ANZ Insurance Cases at 61:185.)

35. A reinsurance contract is a contract of indemnity. Under a contract of reinsurance one party known as the reinsurer, promises to indemnify the other party, known as the reinsured, for any financial losses sustained by the reinsured as a result of the occurrence of an uncertain event originally insured by the reinsured in its business of insurance. In return for this indemnity, the reinsured agrees to pay the reinsurer an amount known as a premium. Reinsurance contracts, therefore, are concerned with providing for the reinsurance of risks under contracts of insurance.

36. A reinsurer indemnifies an insurance company under a contract of reinsurance against risk(s) originally assumed by the insurance company under a contract of insurance. A reinsurance contract provides that the reinsurer will indemnify a portion of the risk in specific proportions to the amount of risk originally assumed or alternatively they may provide for protection over and above a specified amount or ratio of claims. Reinsurance involves the transfer of insurance risk from an insurer to a reinsurer and this transfer exposes a reinsurer to the possibility of incurring a loss under a reinsurance contract as it relates to the risk assumed by the reinsurer.

11.  Further, in Hannover Life Re of Australasia Ltd v Commissioner of Taxation [2023] FCA 680, Stewart J described the legal effect of reinsurance as follows (at [38] to [39]):

...where the applicant cedes risk it has taken on from its issuing of insurance policies, the ceding of that risk is reinsurance. Where the applicant cedes risk it has taken on from its providing reinsurance to other insurers, the ceding of that risk is referred to as "retrocession".

The legal mechanism by which the applicant cedes its risk to another insurer, such as Hannover Rück, involves the applicant having a contractual right to receive in certain circumstances a payment in respect of the extent of the ceded risk. ...

12.  The Reinsurance Treaty is a contract under which Australian Insurer has ceded, and Resident Reinsurer has agreed to indemnify Australian Insurer against, a portion of the risk originally assumed by Australian Insurer under the Insurance Policy.

13.  This exposes Resident Reinsurer to the possibility of incurring a loss as it relates to the risk it has assumed under the Reinsurance Treaty for the Business Covered. In return for this indemnity, Australian Insurer has agreed to pay Resident Reinsurer the Reinsurance Premium in accordance with the Amendment to the Reinsurance Treaty.

14.  The Reinsurance Treaty is not covered by one of the exclusions in the definition of 'contract of reinsurance' in subsection 995-1(1).

15.  Accordingly, the Reinsurance Treaty is a 'contract of reinsurance' in respect of a 'life insurance policy' for the purposes of Division 320.

Life insurance premium

16.  Subsection 995-1(1) does not provide an exhaustive definition of the term 'life insurance premium'. It instead provides that a 'life insurance premium' includes consideration received or receivable in respect of the grant of, or the undertaking of liabilities in respect of, an 'annuity' or a 'personal injury lump sum'.

17.  A Reinsurance Premium paid by Australian Insurer to Resident Reinsurer under the Reinsurance Treaty is not received by Resident Reinsurer in respect of the grant of, or the undertaking of liabilities in respect of, an 'annuity' (as defined in subsection 995-1(1)) or a 'personal injury lump sum' (as defined in section 54-5).

18.  However, as the definition under subsection 995-1(1) is not exhaustive, the term 'life insurance premium' may be interpreted according to its ordinary meaning, having regard to the context in which it appears.

19.  In Commissioner of State Revenue v Royal and Sun Alliance Insurance Australia Ltd. [2003] VSCA 177,the Court discussed the ordinary meaning of the word 'premium' in the context of the Stamps Act 1958 (Vic) and said (at [27]):

As ordinarily understood, a premium is the consideration, usually in the form of a monetary obligation, paid or payable by the insured for the grant or renewal of insurance cover or of other rights under a policy of insurance.

20.  Further, the Explanatory Memorandum to the New Business Tax System (Miscellaneous) Bill (No. 2) 2000 (the EM), which introduced section 320-100, explains (at paragraph 5.32) that a life insurance premium is any amount paid by a policyholder for a life insurance policy and includes the amount paid to purchase an annuity.

21.  In the context of section 320-100, the EM states (at paragraphs 5.93 and 5.95) that a life insurance company will be entitled to a deduction for premiums paid under contracts of reinsurance only if the contract provides for the transfer of risk of loss from the occurrence of contingent insured events. The transfer of risk is made through the indemnity to the life insurance company that enters into the reinsurance contract in respect of losses that it suffers as a consequence of carrying on risk business. If the arrangement does not transfer the risk to a reinsurer (as under a financial reinsurance contract), the premiums paid are not deductible as the arrangement is not considered to be a reinsurance contract (the EM, at paragraph 5.96).

22.  Having regard to the relevant facts and circumstances, the Reinsurance Treaty provides for the transfer of risk of loss from the occurrence of contingent insured events from Australian Insurer to Resident Reinsurer in respect of XX% of the Business Covered. The Reinsurance Premium is the amount paid by Australian Insurer to Resident Reinsurer as consideration for the ceding of that risk and the provision of reinsurance cover for the Business Covered.

23.  Therefore, the Reinsurance Premium is a premium paid by Australian Insurer to Resident Reinsurer under a contract of reinsurance which provides for the transfer of risk of loss from Australian Insurer to Resident Reinsurer through the indemnity to Australian Insurer in respect of losses that it suffers as a consequence of carrying on risk business. Accordingly, the Reinsurance Premium is a 'life insurance premium' for the purposes of section 320-100.

Subsection 148(1) of the ITAA 1936

24.  Based on paragraph 320-100(b), a life insurance company can only deduct amounts under section 320-100 that do not relate to a risk, or part of a risk, in relation to which subsection 148(1) of the ITAA 1936 applies.

25.  Subsection 148(1) of the ITAA 1936 only applies in respect of persons carrying on the business of insurance in Australia who reinsure out of Australia the whole or part of any risk with a non-resident.

26.  As Resident Reinsurer is an Australian resident for tax purposes, subsection 148(1) of the ITAA 1936 does not apply in respect of any amounts paid by Australian Insurer to Resident Reinsurer under the Reinsurance Treaty. Therefore, the Reinsurance Premium does not relate to a risk, or part of a risk, in relation to which subsection 148(1) of the ITAA 1936 applies.

Conclusion

27.  Accordingly, a Reinsurance Premium paid by Australian Insurer to Resident Reinsurer under the Reinsurance Treaty will be deductible to Australian Insurer under section 320-100.

Question 2

Where an Additional Payment is made by Resident Reinsurer to Australian Insurer pursuant to the Reinsurance Treaty, will the Additional Payment amount be included in Australian Insurer's assessable income under paragraph 320-15(1)(b)?

Summary

An Additional Payment made by Resident Reinsurer to Australian Insurer pursuant to the Reinsurance Treaty will be included in Australian Insurer's assessable income under paragraph 320-15(1)(b). This is because the Additional Payment will be an amount received or recovered under a 'contract of reinsurance', the full amount of which relates to the 'risk components' of claims paid under a 'life insurance policy'. Further, the Additional Payment amount does not relate to a risk (or part of a risk) in relation to which subsection 148(1) of the ITAA 1936 applies.

Detailed reasoning

Paragraph 320-15(1)(b)

1.     A taxpayer's assessable income consists of 'ordinary income' and 'statutory income' (subsection 6-1(1)). Statutory income is comprised of amounts that are not ordinary income but are included in a taxpayer's assessable income by provisions about assessable income (section 6-10).

2.     Subdivision 320-B, which includes section 320-15, provides for certain amounts to be included in a life insurance company's assessable income, including amounts received under a contract of reinsurance (section 320-10).

3.     In particular, paragraph 320-15(1)(b) provides that:

(1)    A *life insurance company's assessable income includes:

(2)    ...

(b)  amounts received or recovered under *contracts of reinsurance (except amounts that relate to a risk, or part of a risk, in relation to which subsection 148(1) of the Income Tax Assessment Act 1936 applies) to the extent to which they relate to the *risk components of claims paid under *life insurance policies; and...

4.     Australian Insurer is a 'life insurance company' according to subsection 995-1(1), as it is a company registered under section 21 of the Life Insurance Act.

5.     In accordance with the reasons for decision for Question 1 of this ruling, the Reinsurance Treaty is a 'contract of reinsurance' in respect of a 'life insurance policy' for the purposes of Division 320.

6.     Therefore, where an Additional Payment is made by Resident Reinsurer to Australian Insurer in accordance with the Amendment to the Reinsurance Treaty, it will be an amount received or recovered by Australian Insurer under a contract of reinsurance.

Subsection 148(1) of the ITAA 1936

7.     Subsection 148(1) of the ITAA 1936 only applies in respect of persons carrying on the business of insurance in Australia who reinsure out of Australia the whole or part of any risk with a non-resident.

8.     As Resident Reinsurer is an Australian resident for tax purposes, subsection 148(1) of the ITAA 1936 does not apply in respect of any amounts received or recovered by Australian Insurer from Resident Reinsurer under the Reinsurance Treaty. Therefore, the Additional Payment does not relate to a risk, or part of a risk, in relation to which subsection 148(1) of the ITAA 1936 applies.

Risk components of claims paid under life insurance policies

9.     Amounts received or recovered under contracts of reinsurance will only be assessable under paragraph 320-15(1)(b) to the extent to which they relate to the 'risk components' of claims paid under 'life insurance policies'.

10.  Under subsection 995-1(1), 'life insurance policy' has the meaning given to the expression 'life policy' in the Life Insurance Act. As the Insurance Policy is a 'life policy' within the meaning of section 9 of the Life Insurance Act, it is therefore a 'life insurance policy' under subsection 995-1(1).

11.  Under subsection 995-1(1), the 'risk component' of a claim paid under a life insurance policy has the meaning given by section 320-80.

12.  Under subsection 320-80(1), a life insurance company can deduct the amounts paid in respect of the 'risk components' of claims paid under life insurance policies during the income year. Subsection 320-80(2) in turn provides that the 'risk component' of a claim paid under a life insurance policy is:

(a)   if:

                            (i)        the policy does not provide for *participating benefits or *discretionary benefits; and

                           (ii)        the policy is neither an *exempt life insurance policy nor a *funeral policy; and

                          (iii)        an amount is payable under the policy only on the death or disability of the insured person;

the amount paid under the policy as a result of the occurrence of that event; or

(b)   if the policy provides for participating benefits or discretionary benefits or is an exempt life insurance policy or a funeral policy-nil; or

(c)    otherwise-the amount paid under the policy as a result of the death or disability of the insured person less the *current termination value of the policy (calculated by an *actuary) immediately before the death, or the occurrence of the disability, of the person.

13.  The Insurance Policy satisfies subparagraph 320-80(2)(a)(i) as it does not provide for 'participating benefits' (within the meaning of section 15 of the Life Insurance Act) or 'discretionary benefits' (as defined in subsection 995-1(1)). In addition, the Insurance Policy satisfies subparagraph 320-80(2)(a)(ii) as it is neither an 'exempt life insurance policy' (within the meaning of section 320-246) nor a 'funeral policy' (as defined in subsection 995-1(1)).

14.  Under subparagraph 320-80(2)(a)(iii), if an amount is payable under a life insurance policy only on the death or disability of the insured person, the risk component of a claim paid under the policy is the amount paid under the policy as a result of the occurrence of that event.

15.  As the word 'disability' is not defined under the ITAA 1997, it may be interpreted according to its ordinary meaning, having regard to the context in which it appears.

16.  Under the Insurance Policy, a benefit is payable upon the Disability or Permanent Incapacity of an Insured Member. Based on the descriptions of Disability and Permanent Incapacity under the Insurance Policy, the Commissioner is satisfied that they each constitute a form of 'disability' within the ordinary meaning of that word. Accordingly, an amount is payable under the Insurance Policy only on the disability of an insured person.

17.  As paragraph 320-80(2)(a) applies, the 'risk component' of a claim paid under the Insurance Policy is the amount paid under the policy as a result of the occurrence of the Disability or Permanent Incapacity of an insured person.

Application to the Additional Payment

18.  The Additional Payment is calculated based on the Estimated Claims (which are in turn based on the Gross Premiums earned by Australian Insurer under the Insurance Policy) and the Current Claims under the Insurance Policy for the relevant Calculation Period.

19.  Accordingly, by virtue of paragraph 320-15(1)(b), an Additional Payment made by Resident Reinsurer to Australian Insurer pursuant to the Reinsurance Treaty will be included in Australian Insurer's assessable income to the extent to which it relates to the amounts paid by Australian Insurer under the Insurance Policy as a result of the occurrence of the disability of an insured person under cover for Disability or Permanent Incapacity.

20.  Under the Additional Payment process, where the Estimated Claims are less than the Current Claims under the Insurance Policy for the relevant Calculation Period (factoring in any previous Additional Payments to adjust for previous Calculation Periods), Resident Reinsurer is required to make an Additional Payment to Australian Insurer. The Current Claims and, in turn, the obligation for Resident Reinsurer to make an Additional Payment to Australian Insurer, arise as a result of claim payments made (and expected to be made) by Australian Insurer under the Insurance Policy due to the Disability or Permanent Incapacity of an Insured Member.

21.  Therefore, the full amount of an Additional Payment received by Australian Insurer under the Reinsurance Treaty relates to the amounts paid, and expected to be paid, by Australian Insurer under the Insurance Policy as a result of the occurrence of the disability of an insured person; that is, the risk component of claims paid under the Insurance Policy.

Conclusion

22.  Consequently, an Additional Payment made by Resident Reinsurer to Australian Insurer pursuant to the Reinsurance Treaty will be included in Australian Insurer's assessable income under paragraph 320-15(1)(b).

Question 3

Where an Additional Payment is made by Australian Insurer to Resident Reinsurer pursuant to the Reinsurance Treaty, will the Additional Payment amount be deductible to Australian Insurer under section 8-1?

Summary

An Additional Payment made by Australian Insurer to Resident Reinsurer pursuant to the Reinsurance Treaty will be deductible to Australian Insurer under section 8-1. This is because the Additional Payment is necessarily incurred by Australian Insurer in carrying on its business for the purpose of gaining or producing assessable income and is not covered by any of the exclusions in subsection 8-1(2).

Detailed reasoning

General deductions under section 8-1

1.    Subdivision 320-C specifies deductions that are available to a life insurance company. In the context of reinsurance, section 320-100 allows a life insurance company to deduct amounts that were paid as 'life insurance premiums' under 'contracts of reinsurance' (that do not relate to a risk, or part of a risk, in relation to which subsection 148(1) of the ITAA 1936 applies).

2.    As set out in the reasons for decision for Question 1 of this ruling, in the context of reinsurance, a life insurance premium for the purposes of section 320-100 is the consideration paid in respect of the provision of reinsurance cover and the transfer of risk of loss from the original insurer to the reinsurer under the contract of reinsurance.

3.    As concluded in Question 1 of this ruling, the Reinsurance Premium paid by Australian Insurer to Resident Reinsurer under the Amendment to the Reinsurance Treaty is a life insurance premium under a contract of reinsurance for the purposes of section 320-100. Under the Reinsurance Treaty, Australian Insurer is contractually obligated to pay the Reinsurance Premium to Resident Reinsurer on a monthly basis irrespective of the actual claims experience in relation to the Gross Premiums received by Australian Insurer.

4.    In contrast, the Additional Payment process under the Reinsurance Treaty provides for any variances between the Estimated Claims and the Current Claims under the Insurance Policy for the relevant Calculation Period to be settled between Australian Insurer and Resident Reinsurer.

5.    Specifically, an Additional Payment is only required to be made by Australian Insurer to Resident Reinsurer where the Estimated Claims are more than the Current Claims for the relevant Calculation Period (factoring in any previous Additional Payments to adjust for previous Calculation Periods). Therefore, the Additional Payment mechanism may not result in an amount being paid by Australian Insurer to Resident Reinsurer for a particular Calculation Period. Rather, Resident Reinsurer may be required to make an Additional Payment to Australian Insurer, or an Additional Payment may not be payable at all.

6.    As such, an Additional Payment made by Australian Insurer to Resident Reinsurer pursuant to the Reinsurance Treaty is not an amount paid as consideration for the ceding of insurance risk and the provision of reinsurance coverage, and it does not affect the grant or renewal of reinsurance cover provided by Resident Reinsurer to Australian Insurer under the Reinsurance Treaty. Rather, it is a separate payment to the Reinsurance Premium, which is contingent on the actual claims outcome for a particular Calculation Period.

7.    Hence, a deduction is not available to Australian Insurer under section 320-100 in respect of an Additional Payment made to Resident Reinsurer.

8.    As there are no other specific deductions that would apply for an Additional Payment, the provision for general deductions in section 8-1 needs to be considered.

9.    Section 8-1 states that:

(1)  You can deduct from your assessable income any loss or outgoing to the extent that:

(a)  it is incurred in gaining or producing your assessable income; or

(b)  it is necessarily incurred in carrying on a *business for the purpose of gaining or producing your assessable income.

...

(2)  However, you cannot deduct a loss or outgoing under this section to the extent that:

(a)  it is a loss or outgoing of capital, or of a capital nature; or

(b)  it is a loss or outgoing of a private or domestic nature; or

(c)   it is incurred in relation to gaining or producing your *exempt income or your *non-assessable non-exempt income; or

(d)  a provision of this Act prevents you from deducting it.

...

10.  The reference to 'this Act' in paragraph 8-1(2)(d) is defined in subsection 995-1(1) to include a reference to the ITAA 1936.

11.  For an Additional Payment that is made by Australian Insurer to Resident Reinsurer pursuant to the Reinsurance Treaty to be deductible under section 8-1, it must therefore satisfy one of the positive limbs in subsection 8-1(1) and not fall within any of the negative limbs in subsection 8-1(2).

The positive limbs of section 8-1

12.  To be deductible under section 8-1, the positive limbs in subsection 8-1(1) require there to be a relevant connection between the Additional Payment that is made by Australian Insurer to Resident Reinsurer and:

a.      the gaining or producing of Australian Insurer's assessable income: paragraph 8-1(1)(a) (the first positive limb); or

b.      the carrying on of Australian Insurer's business of providing life insurance products to customers for the purpose of gaining or producing its assessable income: paragraph 8-1(1)(b) (the second positive limb).

13.  In determining whether an outgoing is characterised as having been incurred in gaining or producing assessable income, the High Court in Ronpibon Tin NL and Tongkah Compound NL v Federal Commissioner of Taxation [1949] HCA 15; (1949) 78 CLR 47 (Ronpibon) held (at 56 to 57) that:

For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end. The words "incurred in gaining or producing the assessable income" mean in the course of gaining or producing such income. ...

14.  In relation to the first positive limb, the High Court in Ronpibon also stated (at 57):

In brief substance, to come within the initial part of the sub-section it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income. ...

15.  To be deductible under the second positive limb, a loss or outgoing must have the character of a working or operating expense of the entity's business or be an essential part of the cost of its business operations (Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues, at paragraph 73). In John Fairfax & Sons Pty Ltd v Federal Commissioner of Taxation [1959] HCA 4; (1959) 101 CLR 30, Menzies J stated (at 48 to 49):

... To be deductible an outlay must be part of the cost of trading operations to produce income, i.e., it must have the character of a working expense. ...

...there must, if an outgoing is going to fall within its terms, be found (i) that it was necessarily incurred in carrying on a business; and (ii) that the carrying on of the business was for the purpose of gaining assessable income. The element that I think is necessary to emphasise here is that the outlay must have been incurred in the carrying on of a business, that is, it must be part of the cost of trading operations. ...

16.  In relation to the second positive limb, the High Court in Ronpibon observed (at 56) that a loss or outgoing will be 'necessarily' incurred in carrying on a business where it is 'clearly appropriate or adapted' for the carrying on of the business.

17.  Further, in Magna Alloys and Research Pty Ltd v Federal Commissioner of Taxation [1980] FCA 180, Deane and Fisher JJ stated that:

... The controlling factor is that, viewed objectively, the outgoing must, in the circumstances, be reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business being carried on for the purpose of earning assessable income. ...

18.  Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith, which provides the Commissioner's view on the deductibility of interest expenses, explains at paragraph 24 that:

Where the taxpayer carries on a business the second limb of section 8-1 requires there to be a relevant connection between the outgoing and the business. In deciding whether the interest is 'necessarily incurred' in the sense of 'clearly appropriate' to that business (FC of T v. Snowden and Willson Pty Ltd (1958) 99 CLR 431), regard must be had to the nature of the business activity (Magna Alloys & Research Pty Ltd v. FC of T 80 ATC 4542; 11 ATR 276), the business purpose for which the outgoing was incurred (FC of T v. The Midland Railway of Western Australia Ltd (1952) 85 CLR 306), the objective circumstances surrounding the incurring of the expenditure (FC of T v. South Australia Battery Makers Pty Ltd (1978) 140 CLR 645) and the character of the expense (John Fairfax & Sons Pty Ltd v. FC of T (1959) 101 CLR 30).

19.  The business carried on by Australian Insurer involves the provision of life insurance products to customers. To manage its risk profile, Australian Insurer's ordinary business activities include entering into reinsurance agreements to reinsure some or all of the risk under its life insurance policies, thus indemnifying itself against losses sustained as a result of carrying on risk business.

20.  Australian Insurer entered into the Amendment to better manage its counterparty exposures and regulatory capital requirements. The Additional Payment mechanism forms part of Australian Insurer's contractual obligations under the Reinsurance Treaty under which Australian Insurer obtains reinsurance coverage for a portion of the risk under the Insurance Policy.

21.  Given the inherent uncertainty with carrying on risk business, the Additional Payment mechanism allows Australian Insurer and Resident Reinsurer to be compensated by way of an Additional Payment where the actual claims experience in respect of the risks ceded is not in line with the claims outcome that was forecast when the parties entered into the Amendment.

22.  Having regard to Australian Insurer's ordinary business activities, where an Additional Payment is required to be made by Australian Insurer to Resident Reinsurer in accordance with the Amendment, it is considered that the Additional Payment has the essential character of an operating expense incurred as an ordinary incident of carrying on Australian Insurer's business of providing life insurance products.

23.  Consequently, an Additional Payment made by Australian Insurer to Resident Reinsurer under the Reinsurance Treaty is necessarily incurred by Australian Insurer in carrying on its business for the purpose of gaining or producing assessable income, therefore satisfying the second positive limb in paragraph 8-1(1)(b).

The negative limbs of section 8-1

24.  As an Additional Payment made by Australian Insurer to Resident Reinsurer satisfies the second positive limb in paragraph 8-1(1)(b), it is necessary to consider whether the Additional Payment is precluded from being deductible under one of the negative limbs in subsection 8-1(2).

Paragraph 8-1(2)(a): outgoing of capital, or of a capital nature

25.  Paragraph 8-1(2)(a) denies a deduction for a loss or outgoing to the extent that it is a loss or outgoing of capital, or of a capital nature.

26.  There is extensive common law authority to guide the consideration of whether an expense or outgoing is of a capital or revenue nature.

27.  In Sun Newspapers Ltd & Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers), Dixon J made the following observation (at 359):

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organization set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss. ...

28.  His Honour then went onto identify the following matters to be considered in characterising an expense or outgoing as being of a capital or revenue nature (Sun Newspapers, at 363):

There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

29.  The character of the advantage sought is often regarded as being a critical factor in characterising the nature of an expense or outgoing. This was emphasised by the decision of the High Court in GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation [1990] HCA 25; (1990) 170 CLR 124, where it was held (at 137) that:

The character of expenditure is ordinarily determined by reference to the nature of the asset acquired or the liability discharged by the making of the expenditure, for the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid. ...

30.  In Hallstroms Pty Ltd v Federal Commissioner of Taxation [1946] HCA 34; (1946) 72 CLR 634, Dixon J stated (at 648) that:

What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process. ...

31.  Further, as identified by Gibbs ACJ in Federal Commissioner of Taxation v South Australian Battery Makers Pty Ltd [1978] HCA 32; (1978) 140 CLR 645 at 655, the real question may be:

... not to determine the character of the advantage sought, once it has been identified, but to decide what was the advantage sought by the taxpayer by making the payments. ...

32.  More recently, the High Court provided the following guidance in Federal Commissioner of Taxation v Sharpcan Pty Ltd [2019] HCA 36 at [18]:

Authority is clear that the test of whether an outgoing is incurred on revenue account or capital account primarily depends on what the outgoing is calculated to effect from a practical and business point of view. Identification of the advantage sought to be obtained ordinarily involves consideration of the manner in which it is to be used and whether the means of acquisition is a once-and-for-all outgoing for the acquisition of something of enduring advantage or a periodical outlay to cover the use and enjoyment of something for periods commensurate with those payments. Once identified, the advantage is to be characterised by reference to the distinction between the acquisition of the means of production and the use of them; between establishing or extending a business organisation and carrying on the business; between the implements employed in work and the regular performance of the work in which they are employed; and between an enterprise itself and the sustained effort of those engaged in it. Thus, an indicator that an outgoing is incurred on capital account is what it secures is necessary for the structure of the business.

33.  From a practical and business point of view, the Additional Payment is not a 'once-and-for-all outgoing' for the acquisition of something of enduring advantage for Australian Insurer's business structure. Rather, it is a periodic payment, which is contingent on the actual claims experience for a particular Calculation Period. In this regard, the Additional Payment process outcome may vary periodically, with no Additional Payment being required to be made by Australian Insurer for some Calculation Periods.

34.  Having regard to the relevant facts and circumstances, an Additional Payment made by Australian Insurer to Resident Reinsurer under the Reinsurance Treaty is not an outgoing of capital, or of a capital nature, for the purposes of paragraph 8-1(2)(a).

Paragraphs 8-1(2)(b), (c) and (d)

35.  Considering the other negative limbs in subsection 8-1(2), an Additional Payment made by Australian Insurer to Resident Reinsurer:

a.    is not of a private or domestic nature (paragraph 8-1(2)(b)) and is not incurred in relation to gaining or producing exempt income or non-assessable non-exempt income (paragraph 8-1(2)(c)), as it is necessarily incurred by Australian Insurer in carrying on its business for the purpose of gaining or producing assessable income; and

b.    is not subject to a provision of the ITAA 1997 or the ITAA 1936 that would prevent it from being deducted (paragraph 8-1(2)(d)).

36.  Therefore, an Additional Payment made by Australian Insurer to Resident Reinsurer under the Reinsurance Treaty does not fall within any of the negative limbs of subsection 8-1(2).

Conclusion

37.  Accordingly, an Additional Payment made by Australian Insurer to Resident Reinsurer pursuant to the Reinsurance Treaty will be deductible to Australian Insurer under section 8-1.