Taxable
income was increased by over $63 million after the Court of Appeal ruled
against attempts by Sovereign Assurance to exploit timing differences on
payments attached to reinsurance contracts.
Late payment penalties have increased Sovereign’s tax bill to nearly $90
million because the tax dispute has dragged on for so long.
ASB Bank purchased
Sovereign Assurance in 1998. With the
purchase it inherited reinsurance contracts already in place with German
reinsurer: Gerling-Konzern Globale. ASB Bank wound down operation of these
contracts between 2001 and 2004.
Evidence was given
that the Gerling reinsurance contracts included a financing component. As well as underwriting Sovereign’s risk on
life contracts, Gerling provided working capital to fund the first few years of
life policies. Life insurers incur heavy
establishment expenses when setting up a new policy: administrative fees,
medical expenses and agent’s commission incur immediate costs which typically
amount to a multiple of two to three times the first year premium.
Gerling agreed to
advance funds to cover Sovereign’s life policy establishment costs with an
agreed mechanism for repayment of this advance plus interest.
Sovereign included as
taxable income in the year of receipt the Gerling advances and later claimed the
repayment as a tax deduction in the year paid.
The timing differences between a smaller sum claimed as income and a
larger sum claimed later as a deduction provided a substantial tax benefit: in
2001 this amounted to $23.6 million; in 2002, $39.9 million.
Sovereign argued that
the contract sat outside the tax rules for “financial arrangements” because it
was not a financing transaction but rather a sale of property – the property sold
being the cash flows arising from premiums paid on individual life policies.
The Court of Appeal
said the wording of the contract did not support this argument. While the Gerling contract was in German and
used specialist terminology found in reinsurance contracts, with talk of
“cession” and “acceptance”, these words described risk exposure, not the sale
of an asset.
For tax, the financing
component of the reinsurance contract was treated as a loan. As a “financial arrangement”, Sovereign could
claim a tax deduction only for the interest component. The working capital advanced was not
assessable income, and repayment of that capital was not deductible.
Sovereign
Assurance v. Inland Revenue – Court of Appeal (17.12.13)
14.001