House of Representatives

Explanatory Memorandum

Circulated By the Authority of the Treasurer, the Hon Wayne Swan MP

Chapter 6 - General insurance rewrite - Schedule 2J

Outline of chapter

6.1 Schedule 5 to this Bill rewrites the provisions in Schedule 2J to the Income Tax Assessment Act 1936 ( ITAA 1936) to the Income Tax Assessment Act 1997 ( ITAA 1997).

Context of amendments

6.2 Schedule 2J to the ITAA 1936 specifies the taxation treatment of general insurance companies in respect of:

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liabilities in respect of the provision for, and payment of, outstanding claims - that is, outstanding claims liabilities; and

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premium income.

6.3 This Schedule also specifies the taxation treatment of the outstanding claims liabilities of companies that self-insure in respect of workers' compensation liabilities.

6.4 The effect of this Schedule is to effectively spread the income and deductions of a general insurance company, and the deductions of a company that self-insures in respect of workers' compensation liabilities, over the period to which the income and deductions relate.

Detailed explanation of new law

6.5 The rewrite repeals Schedule 2J and reproduces its effect in the ITAA 1997 . [Schedule 5, items 1 and 2, Division 321]

How the rewrite is different

6.6 The provisions in the rewrite follow the same order as the provisions in Schedule 2J. The main changes are that:

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the provisions have been slightly restructured;

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Division 321 of Schedule 2J (which applies to general insurance companies) is in Subdivisions 321-A and 321-B of the rewrite; and

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Division 323 of Schedule 2J (which applies to companies that self-insure in respect of workers' compensation liabilities) is in Subdivision 321-C of the rewrite;

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the basis for working out the value of the outstanding claims liabilities of a general insurance company has been modified to clarify that the value of the liabilities is not reduced by recoveries under certain reinsurance policies;

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some provisions have been replaced by method statements; and

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guide material, application provisions and transitional provisions have been omitted.

6.7 The purpose of these changes is to clarify and simplify the presentation of the ideas already expressed in Schedule 2J.

Differences in Subdivisions 321-A and 321-B - General insurance companies

6.8 Subdivisions 321-A and 321-B specify the taxation treatment of general insurance companies in respect of:

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the provision for, and payment of, outstanding claims liabilities; and

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premium income.

Subdivision 321-A - Provision for, and payment of, claims by general insurance companies

Provision for outstanding claims liabilities

6.9 Subdivision 321-A specifies the taxation treatment of general insurance companies in respect of the provision for outstanding claims liabilities.

6.10 The provisions compare the value of a general insurance company's outstanding claims liabilities at the end of an income year with the value of those liabilities at the end of the previous income year.

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If the value of the outstanding claims liabilities at the end of an income year is less than the value at the end of the previous income year, the difference is included in assessable income.

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If the value of the outstanding claims liabilities at the end of an income year exceeds the value at the end of the previous income year, the excess is allowed as a deduction.

[Schedule 5, item 2, sections 321-10 and 321-15]

6.11 The rewrite uses a method statement to specify the basis for working out the value of a general insurance company's outstanding claims liabilities under general insurance policies at the end of an income year . [Schedule 5, item 2, section 321-20]

6.12 The first step in the method statement is to add up the amounts that, at the end of an income year, the general insurance company determines, based on proper and reasonable estimates, to be appropriate to set aside and invest in order to meet:

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outstanding claims liabilities under those general insurance policies; and

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direct settlement costs associated with those outstanding claims liabilities.

[Schedule 5, item 2, step 1 in the method statement in section 321-20]

6.13 The second step in the method statement is to reduce the step 1 amount by the amount that the company expects to recover:

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under a contract of reinsurance; or

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in any other way.

[Schedule 5, item 2, step 2 in the method statement in section 321-20]

6.14 However, the step 1 amount is not reduced by the amount that the company expects to recover under a contract of reinsurance to which subsection 148(1) of the ITAA 1936 applies . [Schedule 5, item 2, step 2 in the method statement in section 321-20]

6.15 The amount worked out under step 1 in the method statement reflects the present value of the estimated outstanding claims liabilities of a general insurance company. Step 2 reduces this amount by the amount that the company expects to recover because, for example, the company has reinsured some or all of the liabilities. Therefore, the step 2 amount is the present value of the estimated recoveries.

6.16 The rewrite clarifies that the value of a general insurance company's outstanding claims liabilities is not reduced by the amount that the company expects to recover under a contract of reinsurance to which subsection 148(1) of the ITAA 1936 applies.

6.17 Subsection 148(1) applies, so far as is relevant, to a reinsurance policy taken out by a general insurance company carrying on business in Australia with a non-resident company. If the subsection applies, broadly:

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the Australian general insurance company cannot deduct premiums paid in respect of the policy and is not assessable on any reinsurance recoveries; and

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the non-resident reinsurance company is not assessed in Australia on the premiums received or receivable.

6.18 If subsection 148(1) applies to a contract of reinsurance which is taken out by a general insurance company, the premiums and recoveries under the reinsurance contract are effectively ignored in working out the reinsured company's taxable income.

6.19 Under step 2 in the method statement, the value of the reinsured company's outstanding claims liabilities is not reduced by the amount the company expects to recover under the reinsurance contract. If step 2 was reduced by this amount, the reinsured company's taxable income would effectively be increased by the amount of the expected reinsurance recoveries. This would be inconsistent with the objective of subsection 148(1).

Payment of outstanding claims liabilities

6.20 Subdivision 321-A also specifies the taxation treatment of general insurance companies in respect of the payment of outstanding claims liabilities.

6.21 A general insurance company can deduct the amounts paid during an income year in respect of claims under general insurance policies . [Schedule 5, item 2, section 321-25]

6.22 In this context, a claim is taken to be paid by a general insurance company in an income year even though the funds have not actually been disbursed at the end of the income year provided that:

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the amount of the claim is settled in that income year;

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the relevant liability is no longer reflected in the company's outstanding claims liabilities at the end of that income year; and

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the claim is payable by the company at the end of that income year.

Subdivision 321-B - Premium income of general insurance companies

6.23 Subdivision 321-B specifies the taxation treatment of general insurance companies in respect of premium income.

6.24 Gross premium income received or receivable in respect of general insurance policies in an income year is included in a general insurance company's assessable income . [Schedule 5, item 2, section 321-45]

6.25 The value of a general insurance company's unearned premium reserve under general insurance policies issued in the course of carrying on insurance business which relate to risks covered by those policies in respect of later income years must be worked out at the end of each income year.

6.26 The value of the unearned premium reserve at the end of an income year is then compared with the value of that reserve at the end of the previous income year:

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If the value of the unearned premium reserve at the end of an income year is less than the value at the end of the previous income year, the difference is included in assessable income.

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If the value of the unearned premium reserve at the end of an income year exceeds the value at the end of the previous income year, the excess is allowed as a deduction.

[Schedule 5, item 2, sections 321-50 and 321-55]

6.27 The rewrite uses a method statement to specify the basis for working out the value of a general insurance company's unearned premium reserve at the end of an income year . [Schedule 5, item 2, section 321-60]

6.28 The first step in the method statement is to add up gross premiums received or receivable in the income year, or in an earlier income year, in relation to general insurance policies issued by the company in the course of carrying on insurance business . [Schedule 5, item 2, step 1 in the method statement in section 321-60]

6.29 The premiums received or receivable by a general insurance company in an income year include premiums paid in respect of a general insurance policy where:

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the policy was originally issued in the course of another company's insurance business; and

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the policy has been transferred to the general insurance company under a portfolio transfer.

6.30 The second step in the method statement is to reduce the step 1 amount by so much of the costs incurred by the company in connection with the issue of those policies that relate to the gross premiums, including:

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commission and brokerage fees;

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administration costs of processing insurance proposals and renewals;

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administration costs of collecting premiums;

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selling and underwriting costs;

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fire brigade charges;

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stamp duty; and

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other charges, levies and contributions imposed by governments or governmental authorities that directly relate to general insurance policies.

[Schedule 5, item 2, step 2 in the method statement in section 321-60]

6.31 The third step in the method statement is to reduce the step 2 amount by the amount of any relevant reinsurance premiums paid or payable by the company in the income year or in an earlier income year. The relevant reinsurance premiums are premiums paid or payable for the reinsurance of risks covered by the general insurance policies issued by the company except:

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reinsurance premiums that the company cannot deduct because of subsection 148(1) of the ITAA 1936; and

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reinsurance premiums that were paid or payable in respect of a particular class of insurance business where, under the contract of reinsurance, the reinsurer agreed to pay, in respect of the loss incurred by the company that is covered by the relevant policy, some or all of the excess over an agreed amount.

[Schedule 5, item 2, step 3 in the method statement in section 321-60]

6.32 The fourth step in the method statement is to increase the step 3 amount by the amount of any reinsurance commissions received or receivable by the company that relate to relevant reinsurance premiums . [Schedule 5, item 2, step 4 in the method statement in section 321-60]

6.33 Under step 5 in the method statement, the value at the end of an income year of the unearned premium reserve of a general insurance company is so much of the step 4 amount that the company determines, based on proper and reasonable estimates, to relate to risks covered by the policies in respect of later income years . [Schedule 5, item 2, step 5 in the method statement in section 321-60]

6.34 The unearned premium reserve relates to risks in respect of later years. Therefore, steps 1 to 4 in the method statement only take into account, broadly:

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premiums in relation to which there is an unexpired risk at the end of an income year; and

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the relevant costs, reinsurance premiums and commissions relating to those premiums.

Guide material omitted

6.35 Guide material in existing sections 321-1, 321-5 and 321-40 of Schedule 2J has been omitted from the rewrite. This is because the provisions are quite short and are self explanatory. As a result, the guide material is unnecessary.

Application and transitional provisions omitted

6.36 The application and transitional provisions in sections 321-30, 321-35 and 321-65 of Schedule 2J have been omitted from the rewrite. These provisions:

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ensured that Subdivision 321-A in Schedule 2J (which relates to the provision for, and payment of, claims) applied to the insurance business, other than reinsurance business, of a general insurance company for the 1991-92 income year and subsequent income years;

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specified the basis for applying Subdivision 321-A to the insurance business, other than reinsurance business, of a general insurance company in the 1991-92 income year;

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ensured that Subdivision 321-A in Schedule 2J (which relates to the provision for and payment of claims) applied to the reinsurance business of a general insurance company for the 1995-96 income year and subsequent income years;

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specified the basis for applying Subdivision 321-A to the reinsurance business of a general insurance company in the 1995-96 income year; and

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ensured that Subdivision 321-B in Schedule 2J (which relates to premium income) applied to a general insurance company for the 1999-2000 income year and subsequent income years.

6.37 These application and transitional provisions have been omitted from the rewrite because they are redundant.

Differences in Subdivision 321-C - Companies that self-insure in respect of workers' compensation liabilities

6.38 Subdivision 321-C specifies the taxation treatment of the outstanding claims liabilities of companies that self-insure in respect of workers' compensation liabilities.

6.39 The provisions apply to a company that is not required by law to insure, and does not insure, against liability for workers' compensation claims that:

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arose from events that occurred in the current year or in an earlier income year; and

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were not paid in full before the end of the current year.

[Schedule 5, item 2, paragraphs 321-80(a) and (b), 321-85(a) and (b)]

6.40 The provisions compare the value of the company's outstanding liabilities for workers' compensation claims at the end of an income year with the value of those liabilities at the end of the previous income year.

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If the value of the outstanding claims liabilities at the end of an income year is less than the value at the end of the previous income year, the difference is included in assessable income.

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If the value of the outstanding claims liabilities at the end of an income year exceeds the value at the end of the previous income year, the excess is allowed as a deduction.

[Schedule 5, item 2, paragraphs 321-80(b) and 321-85(b)]

6.41 The value, at the end of an income year, of a company's outstanding liabilities for workers' compensation claims is worked out by adding up the amounts that, at the end of that income year, the company determines, based on proper and reasonable estimates, to be appropriate to set aside and invest in order to meet:

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liabilities for those claims; and

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direct settlement costs associated with those liabilities.

[Schedule 5, item 2, section 321-90]

6.42 The company can deduct the amounts paid during an income year in respect of workers' compensation claims . [Schedule 5, item 2, section 321-95]

6.43 In this context, a workers' compensation claim is taken to be paid in an income year if:

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the amount of the claim is settled in that income year;

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the relevant liability is no longer included in the company's outstanding claims liabilities at the end of that income year; and

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the claim is payable by the company at the end of that income year.

Guide material omitted

6.44 Guide material in existing section 323-1 of Schedule 2J has been omitted from the rewrite. This is because the provisions are self explanatory. As a result, the guide material is unnecessary.

Application provisions omitted

6.45 The application provision in section 323-25 of Schedule 2J has been omitted from the rewrite. This provision ensured that Division 323 in Schedule 2J applied to a company that self-insures in respect of its workers' compensation liabilities for the 1996-97 income year and subsequent income years. The provision has been omitted from the rewrite because it is redundant.

Application and transitional provisions

6.46 The rewrite applies to the first income year starting on or after the day that the Act receives Royal Assent and later income years . [Schedule 5, item 13]

Consequential amendments

6.47 The amendments update references in the law to Schedule 2J provisions that are rewritten into the ITAA 1997 . [Schedule 5, items 6 to 12, sections 10-5, 12-5 and 713-710]

6.48 The amendments also repeal redundant definitions in the ITAA 1936 and clarify that the definition of 'contract of reinsurance' in subsection 995-1(1) only applies to relevant policies issued by life insurance companies . [Schedule 5, items 3 to 5 and 16, definition of 'contract of reinsurance' in subsection 995-1(1)]

Legislative history of Schedule 2J

6.49 Schedule 2J to the ITAA 1936 was added by the Taxation Laws Amendment Act (No. 3) 2002 [ Act No. 97 of 2002].

6.50 No amendments have been made to Schedule 2J.