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R.A.C. Insurance Pty. Ltd. v. Federal Commissioner of Taxation

Judges:
Lee J

Court:
Federal Court

Judgment date: Judgment handed down 9 August 1989.

Lee J.

These are four appeals by R.A.C. Insurance Pty. Ltd. (``the taxpayer'') under subsec. 189(3) of the Income Tax Assessment Act 1936 (``the Act'') against decisions of the respondent (``the Commissioner'') disallowing objections against assessments of tax issued by the Commissioner under the Act.

The assessments related to years of income ending 30 June 1983, 30 June 1984, 30 June 1985 and 30 June 1986.

The taxpayer lodged objections in respect of each assessment. In due course the Commissioner disallowed the objections. By requests dated 11 June 1985 and 31 July 1985, and pursuant to sec. 187 of the Act as it then stood, the taxpayer requested the Commissioner to treat the objections to the assessments for the years of income ending 30 June 1983 and 30 June 1984 as appeals and forward them to the Supreme Court of Western Australia. Those requests were not acted upon by 1 July 1986 and pursuant to subsec. 226(1) of the Taxation Boards of Review (Transfer of Jurisdiction) Act 1986, thereafter the requests were treated as requests to refer the decisions on the objections to the Supreme Court.

On 14 April 1987 the taxpayer requested the Commissioner to refer his decisions on objections to the assessments for the years of income ending 30 June 1985 and 30 June 1986 to the Supreme Court. All four decisions were referred to the Supreme Court on 21 July 1987. The hearing of proceedings in respect of any of the four decisions had not begun before 1 September 1987 and, therefore, by force of the transitional provisions of the Jurisdiction of Courts (Miscellaneous Amendments) Act 1987 (subsec. 4(3)) the proceedings were transferred to the Federal Court of Australia on that day.

In broad terms, the appeals raised two issues. Firstly, had the Commissioner erroneously included as part of the taxable income of the taxpayer profits received by the taxpayer on the realisation of certain investments, it being contended that such profits did not bear the character of income? Secondly, had the Commissioner erroneously included as part of the taxable income of the taxpayer part of an amount received upon the sale or redemption of eligible securities as defined by sec. 23J of the Act which provision required no part of such amount, other than accrued interest, to be taken to be income derived by the taxpayer? The amounts of taxable income in dispute for the successive years of income were, respectively, $68,478, $754,194, $249,870 and $643,996.

The taxpayer was incorporated in April 1947 under the then Companies Act 1943 (W.A.). The taxpayer was formed and its entire shareholding owned by the Royal Automobile Club of Western Australia Incorporated (``the club'') an association of motorists incorporated under the Associations Incorporation Act 1895 (W.A.).

For some years prior to the formation of the taxpayer, the club had sought to secure benefits for club members through lower premiums for motor vehicle insurance by entering agreements with certain insurers to issue policies to club members on favourable terms.

However, the club considered that greater benefits could be achieved for the club membership if the club became directly involved in providing insurance for club members and accordingly the taxpayer was formed.

ATC 4782

At the time of the formation of the taxpayer, the club supplied its members with the following summary of the objectives the club sought to achieve by establishing the taxpayer as an insurer:

``There will be no shareholders' dividends and all surpluses after the establishment of adequate reserves will be returned to members either in the form of increased bonuses, cheaper insurance or additional free services.''

The taxpayer commenced business on 1 June 1947 as an insurer against damage to motor vehicles and against loss occasioned by personal injuries arising out of the use of a motor vehicle. The taxpayer's entry into business was immediately successful and it became one of the major insurers in Western Australia in respect of damage to motor vehicles despite the fact that the taxpayer limited such insurance to members of the club. In due course, the taxpayer's business expanded and in addition to providing insurance for motor vehicles the taxpayer insured dwellings and contents, power boats, special risks and travel risks.

Until March 1988 the taxpayer only offered insurance to club members, but after that date insurance of dwellings and contents was offered to the public.

The club provides various motoring services for members. Its major service is the maintenance of a fleet of vehicles in which officers of the club provide a 24 hour emergency service for members who suffer motor vehicle breakdowns. Another principal service is the detailed mechanical examination of motor vehicles of club members. The club meets the cost of these operations mainly from income derived from membership subscriptions and earnings on investments.

The club has formed two other companies to provide services to members. The club owns the entire shareholding of R.A.C. Travel Services Pty. Ltd., a company carrying on business as a travel agency and providing its services to the public as well as to members, and R.A.C. Finance Limited, a financial corporation providing financial services to members of the club.

The club and the taxpayer have, at all times, shared the occupation of common premises and club staff have been made available for the use of the taxpayer. Historically, the club acquired the fixed assets of land and buildings in which the club conducted its affairs and the taxpayer operated its business, but in recent years the taxpayer has made such acquisitions and shared the use of such premises with the club.

At all material times the club was in a sound financial position and as at 31 August 1986 the balance sheet for the club showed the net assets of the club to be approximately $11.3m.

The club's objective that the taxpayer provide insurance at a favourable premium for club members was apparently satisfied and the taxpayer was a market leader in setting premium rates in respect of motor vehicle insurance. As a result the business activities of the taxpayer attracted new members to the club keen to have the benefit of insurance at a lower cost thereby increasing the subscription income available to the club.

The affairs of the club were managed by a committee of the members later described as the council of the club. The board of directors of the taxpayer was comprised of some of the members of the council but not all, and for some years until 1982 included a Mr Barrington who was the general manager of the taxpayer but not a member of the council of the club.

Since commencing business the taxpayer has protected its exposure as an insurer by obtaining cover under reinsurance contracts. The amount of reinsurance required was assessed from year to year, but was usually between 1 per cent to 2 per cent of the total annual sum insured. The total annual sum insured was an estimate of the number of risks to be insured in that year and of the probable exposure thereunder. The amount of reinsurance obtained was that considered by the taxpayer to be a realistic assessment of the extent of the risk of the occurrence of a catastrophic event such as a major fire, cyclone or earthquake from which massive claims may result. The cost of reinsurance was regarded as an item to be met by earned premium income and that cost controlled, as far as possible, by obtaining competitive quotations for such cover from insurance brokers and by the taxpayer being prepared to bear the initial part of the risk from its own resources in the event of a catastrophe. The taxpayer's major exposure in that regard, of course, was in respect of

ATC 4783

dwelling and contents insurance and the insurer limited its exposure to some degree by providing no cover for flood damage during the years of income concerned. It has provided such cover in subsequent years.

In conducting its insurance business, it was the longstanding policy of the taxpayer, as adopted by its board of directors, to endeavour to provide for the underwriting activity of the business to be run at a break-even level or at a small profit. It was not the policy of the board to augment the taxpayer's underwriting activities by the use of income from investments.

On several occasions when the taxpayer sought to meet or intensify competition in the marketplace for motor vehicle insurance, it budgeted for small underwriting losses. That was an option available to the taxpayer but it was not a reflection of regular policy.

The nature of the insurance business in which the taxpayer was involved was principally ``short-tail'' insurance, with the exception of insurance of loss occasioned by personal injuries arising out of the use of a motor vehicle. In respect of the latter insurance, the taxpayer was a member of a pool of such insurers operating as the Motor Vehicle Insurance Trust until 30 June 1981. At that time the taxpayer withdrew from the pool and from that field of insurance. The taxpayer had a potential run-off liability as a former member of the pool, but apparently that liability was not regarded as significant according to the lack of provision for it in the accounts of the taxpayer in the following years.

The type of insurance written by the taxpayer meant that the nature and extent of the claims to be paid would be apparent within, or soon after, the period of insurance and no latent liability was required to be assessed.

The prediction of the amount payable on the risks undertaken was, therefore, able to be done with confidence and without actuarial advice. The business did not require long-term provisions for emerging claims and payouts on the policies written were not inevitable as in the case of life assurance.

In preparing an annual budget for an underwriting surplus, the taxpayer expected its annual premium income to exceed payments, or provisions for payments, in respect of claims expected to be received. The budgets did not include any amount for the writing back of the provisions for claims after assessment of the claims unlikely to proceed at the end of the financial year. The board preferred to have budgets prepared on a conservative basis which excluded consideration of provision for the writing back of the provision for claims. As a matter of practice, however, writing back of such provision was included in the final accounts prepared for each financial year. The inclusion of the amounts written back prevented underwriting losses occurring on several occasions, but underwriting losses were incurred in the financial years ending 30 June 1986 and 30 June 1987. An underwriting loss had been anticipated in the budget prepared for the latter year.

The growth and strength of the taxpayer's business resulted from the efforts of its general manager, Mr Barrington, over a number of years. Mr Barrington was responsible for the management of the insurance business and of the investment portfolio of the taxpayer until his retirement in 1982. Mr Barrington recognised that the taxpayer was a relatively small enterprise and that it needed to expand to be able to compete with much larger entities in the field.

Decisions and formulation of policy on investment had been left to the general manager and it was not until 1974 that an investment committee of the board was formed to make such decisions in respect of the taxpayer's investments. It had been Mr Barrington's policy to invest in debentures and government or semi-government bonds, such moneys as he considered to be surplus to cash flow requirements. Occasionally some of those funds were invested in shareholdings described as ``blue chip''.

When in April 1974 an investment committee was formed, it was comprised of some of the members of the board and several executive officers of the taxpayer. Very often that committee's deliberations were conducted through a series of telephone calls. Otherwise it met when the board of the taxpayer met.

The day-to-day management of the investment portfolio was carried out by managerial staff. The chairman of the board received a monthly schedule recording the investments and their dates of maturity and the board members received a quarterly report.

ATC 4784

In 1982 R.A.C. Insurance Investments Pty. Ltd. (``the investment company'') was incorporated. The shareholding of the investment company was wholly owned by the taxpayer and not by the club directly. After the formation of the investment company the taxpayer and the investment company shared an identical board of directors and board meetings were, therefore, always conducted on the same day. At the time the investment company was formed, the investment committee of the taxpayer became the whole board of the taxpayer. The committee also operated as the investment committee of the investment company. The role of the investment company will be discussed below.

The premium income of the taxpayer provided a substantial cash flow which required, or permitted, a mix of investments to be undertaken. On the one hand there were investments in the short-term money market and short-term investments maturing in the course of the financial year which were reincorporated in the cash flow of the taxpayer to meet claims as they arose.

On the other hand, funds of the company which were not required to meet the estimated level of claims from year to year were invested in shares, debentures, government bonds and in loans on first mortgage security. The taxpayer had no firm policy in respect of investments in shares. It was said that, in addition to assessing the potential yield, the board considered whether the investment would assist a company based in Western Australia. Usually, such a consideration would be more relevant to an allotment than a purchase in the market. Some shareholdings were obtained by allotment and others were obtained by acquisitions in the market, but almost all such investments were regarded as ``blue chip''. The taxpayer, prudently, may have expected such investments to retain their value or appreciate in value and to be readily negotiable if required. In the 10 years to 30 June 1986 the taxpayer made 59 acquisitions of shareholdings in 49 companies. In that period the taxpayer made only 13 sales of shares of which nine disposals resulted from takeover offers accepted by the taxpayer.

The government bonds and semi-government securities and debentures were chosen as investments for terms of three to five years, but not more than five years. It was the pattern of the taxpayer's business to hold those investments until maturity and often to reinvest the maturing investments depending upon the yield on offer.

Moneys lent on the security of mortgages against real estate were also short-term in length, rarely more than three years and lent at fixed rates of interest.

For the purpose of its business, the taxpayer invested funds in a variety of investments that provided either an adequate yield or, alternatively, yield and opportunity for appreciation. The investments were negotiable, were medium to short-term in length and all such investments were prudent and not speculative. The taxpayer had no policy that any fixed proportions be invested in particular divisions of investment.

In the 10 years to 30 June 1986 there were 187 investments in debentures, semi-government securities and government bonds of which only 13 were not held to the date of maturity and none of those 13 items were disposed of on the market. Five of the items disposed of were debentures subject to early redemption by the issuer of the debentures and the other investments disposed of, government bonds, were transferred to the taxpayer's subsidiary investment company.

The investments transferred by the taxpayer to the investment company were transferred at book value in the financial year ending 30 June 1986 and the value of those securities was included with other funds advanced by the taxpayer to the investment company. In that financial year the investment company resolved to employ fund managers to manage the investment of a fund of $20m advanced to it by the taxpayer.

In carrying on its business as an insurer, the taxpayer was subject to the provisions of the Insurance Act 1973. Pursuant to that Act and the regulations thereunder, the taxpayer was required to maintain a solvency margin. In calculating the solvency margin all reserves of the taxpayer represented by the various investments were taken into account including the value of loans to its subsidiary company.

After the formation of the investment company in 1982, the taxpayer followed a policy of transferring investments to the subsidiary for reinvestment as they matured and transferring to the subsidiary funds which were

ATC 4785

surplus to the then requirements of the taxpayer including such funds generated by the conduct of the taxpayer's business in the course of a financial year. The result of the operation of this policy between the financial years 1982 to 1986 was a marked diminution of the net profits earned by the taxpayer and a substantial increase in the net profit earned by the investment company.

With regard to the payment of dividends to the club, only one such payment was made in the first 15 years of operation of the taxpayer to 1962. After 1962, dividends were paid each year. With the possible exception of the five years between 1962 and 1966, the amount paid to the club by the taxpayer between 1962 and 1986 did not appear to be linked to the size of the profits earned by the taxpayer. As set out above, at the time of formation of the taxpayer, it had been the club's intent that ``all surpluses after the establishment of adequate reserves'' would be returned by the taxpayer to members of the club in the form of bonuses, cheaper insurance and free services.

As the sums deposited with, and investments transferred to, the investment company by the taxpayer increased between 1982 and 1986 and the net profit of the taxpayer decreased accordingly, the proportion of the net profit of the taxpayer, remitted to the club as a dividend, correspondingly increased although it was more or less a fixed sum. If viewed as a proportion of the consolidated profits earned by the taxpayer and the investment company in the years of income 1982-1986, the proportion of such consolidated profits remitted to the club was approximately 10-14 per cent.

Between 1981 and 1985 the taxpayer increased the amount of its general reserve by making annual appropriations from profits. Between 1981 and 1985 the general reserve increased from $15m to $27m. At the same time retained and unallocated profits were not diminished. On 30 June 1981 the amount of retained profits of the taxpayer was $672,000 and as at 30 June 1985 the retained profits stood at $849,000.

Between 1982 and 1985 the investment company began business as the investment arm of the taxpayer. It made no allocations to a general reserve in that period, but by 30 June 1985 had accumulated retained and unallocated profits of $5.5m.

Between 30 June 1985 and 30 June 1988 the taxpayer made no further allocations to its general reserve and at 30 June 1988 unallocated retained profits stood at $1,144,000. In the same financial years the investment company created a general reserve which stood at $12m at 30 June 1988 created by appropriations of $4m from net profits earned and retained in the preceding three financial years. The creation of that reserve was achieved without diminution of the amount standing to the credit of retained and unallocated profits which was $5,728,000 at 30 June 1988. Between 30 June 1982 and 30 June 1987 the taxpayer's net profit dropped from $8,297,255 to $938,166 and in the same period the investment company's net profit increased from $100,782 to $8,573,525.

It can be seen that between 1982 and 1988 the taxpayer promoted the investment company as the entity in which profits of the two companies as a group would be earned.

Between 1982 and 1988 the taxpayer's income from investments fell from approximately $4.7m to $1.5m. At the same time the taxpayer accepted a reduction in its underwriting surplus. In 1982 the underwriting profit was approximately $3.5m. It was only $239,000 in 1988 following two years of underwriting losses. In the same period the net profit of the investment company rose from approximately $100,000 to approximately $8m and at 30 June 1988 the balance sheet of the subsidiary showed that it had an excess of assets over liabilities of approximately $17.7m which was represented by a general reserve of $12m and retained profits of $5.7m. As at 30 June 1988 almost the entire current assets of the taxpayer were represented by amounts receivable from the investment company, being an amount in excess of $48m. At that time the investment company had a sum of $51m placed in short-term deposits. As at that date the taxpayer's non-current investments were its shareholdings, its portfolio of mortgage secured loans, sundry deposits and land and buildings. It no longer held any listed debentures, semi-government bonds or semi-government securities. The non-current investments of the investment company were represented by shareholdings, listed and unlisted debentures, semi-government bonds and securities, sundry deposits, and land and buildings. The taxpayer had replaced a substantial part of its investment portfolio in short-term investments in bonds

ATC 4786

and debentures with a single current asset in the form of a sum deposited with the investment company. Prudently, the investment company matched that short-term liability by investing such a sum in short-term deposits.

The operations of the investment company were included in consolidated accounts prepared for the taxpayer and the investment company for each of the respective years of income the subject of these appeals. In respect of the years of income ending 30 June 1985 and 30 June 1986, the accounts prepared for those periods and adopted by the taxpayer acknowledged that the taxpayer and the investment company were operated predominantly as a group in the motor vehicle and general insurance industry and that the investment income of the group was income received in the course of operating in that industry.

It is in the context of the foregoing facts that the particular transactions of the taxpayer and the nature of the resultant gains obtained by it in the respective years of income are to be considered.

In its income tax returns for each of the years of income, the taxpayer treated gains it had received on the sale of investments as profits of a capital nature. The respondent adjusted the respective returns by treating the net gains, after deduction of losses, as assessable income and by adjusting the taxpayer's taxable income accordingly.

In the year ending 30 June 1983 the net gain received on redemption of debentures and semi-government securities was $68,478. In the year ending 30 June 1984 the taxpayer received a net gain on the redemption of debentures, semi-government securities and government bonds of $123,100 and a profit on the sale of shares of $752,025. In the year ending 30 June 1985 the taxpayer received a gain of $155,950 on the redemption of debentures, semi-government securities and government bonds and a net gain of $93,920 on the sale of shares. In the year ending 30 June 1986 the taxpayer recorded a net loss on the sale of debentures and semi-government securities of $55,125 and a profit on the sale of shares of $699,121, a net gain of $643,996.

It may be accepted that the taxpayer had conducted its business for many years with the intent that the pool of premium income be sufficient to meet the claims arising under the policies issued from year to year. The market provided by the club membership no doubt assisted the fulfilment of that intention, although it appears that in the latter years, being the years of income in question, the taxpayer may have found that the market in its field of insurance became a little more competitive. In response to that challenge the premium levels, in real terms, were reduced in that they were not increased to match increased costs of operation.

It may also be accepted that the experience gained from the company's operations had indicated that the amount of reinsurance obtained by the taxpayer was likely to be adequate to meet any foreseeable catastrophe. However, the taxpayer's business was conducted on conservative lines. The taxpayer had been content to accumulate reserves and apparently such reserves were regarded as necessary for the purposes of the business, perhaps to cover an event, however remote, such as the failure of a reinsurer.

By limiting the dividends repatriated to the parent club, the taxpayer determined that its investments were not surplus to the requirements of its business but represented a necessary reserve for the purposes of that business notwithstanding that in each of the relevant years of income, perhaps consistently with the nature of the business in which it was engaged, the non-current liabilities of the taxpayer were negligible in contrast with the current liabilities.

In the relevant years of income the mix of investments of the taxpayer and utilisation of the funds generated by the premium inflow reflected an intention that such investments as were not in short-term deposits would be in negotiable securities and where the investments were in bonds, debentures or mortgages, the term for maturity or repayment would be usually not more than three years and certainly no more than five. Such assets were regarded for accounting purposes as non-current assets, but with the exception of moneys advanced on mortgage security, the investments were readily realisable in markets trading in those securities. The taxpayer did not trade in those securities in the sense of buying and reselling as soon as appropriate gains could be realised. The shareholdings purchased by the taxpayer were held for their yield and their solidity and were

ATC 4787

sold only when the successful takeover bids made it necessary. At the time of the purchase, all shareholdings were ``blue chip'' investments in nature and not speculative and were readily negotiable if required to be converted for the purposes of the business. The shareholdings were not purchased with the intent of providing income from the trading of them. They were purchased to represent a safe holding for part of the reserves of the taxpayer's business. Similarly, in the main, securities in the form of bonds and debentures were held until maturity.

As may be expected of a prudently conducted insurance company, the taxpayer was diligently engaged in building reserves to better secure its operation. The reserves gave the taxpayer security against possible, albeit unlikely, catastrophic events and permitted the taxpayer to withstand competition if it became necessary to do so.

The activities of the taxpayer show it relied on a policy of carrying on the business at an underwriting profit to enable it to build up reserves. The investment of funds was carried out to obtain firstly, a suitable yield and secondly, security for the money it represented and the worth of that money having regard to the impact of inflation. The investments stood as resources from which funds could be obtained if necessary for the purpose of the business. The income from the yield from these investments maintained the worth of the reserves by contributing to the profits of the business from which accretions to reserve funds could be made. In addition, maturing investments were regularly introduced to the cash flow of the business and necessarily became available for the day-to-day conduct of the business including reinvestment. Part of the operation of the taxpayer's business involved the flow of funds from cash to investments and from investments to cash from which funds the outgoings of the business were met. The final accounts reflecting the year's operation of the business may have shown that the amount of premiums received were sufficient to meet or exceed the costs of operating the insurance business but, in fact, the proceeds of realised investments and investment income were participating elements in the operating activities of the business.

When determining what may be included within the concept of assessable income, the oft-quoted words of the Lord Justice Clerk in
Californian Copper Syndicate v. Harris (1904) 5 T.C. 159 at pp. 165-166 provide an acknowledgement that in respect of the activities of businesses certain gains may be in the nature of income as ordinarily understood when they may not have that character when received in the course of the conduct of the affairs of an individual:

``enhanced values obtained from realisation or conversion of securities may be so assessable, where what is done is not merely a realisation or change of investment, but an act done in what is truly the carrying on, or carrying out, of a business.''

(See also
London Australia Investment Company Limited v. F.C. of T. 77 ATC 4398; (1977) 138 C.L.R. 106 per Gibbs J. at ATC pp. 4402-4403; C.L.R. pp. 115-116;
Australasian Catholic Assurance Co. Ltd. v. F.C. of T. (1959) 100 C.L.R. 502 at p. 506;
General Reinsurance Co. Ltd. v. Tomlinson (1970) 1 W.L.R. 566.)

As the Full Court of the Federal Court pointed out in
Chamber of Manufactures Insurance Limited v. F.C. of T. 84 ATC 4315 at p. 4318; (1983-1984) 15 A.T.R. 599 at p. 603 that principle is not limited to insurance businesses. It applies to all types of businesses. However, as the Full Court of the High Court said in
Colonial Mutual Life Assurance Society Limited v. F.C. of T. (1946) 73 C.L.R. 604 at p. 618:

``profits and losses on the realization of investments of the funds of an insurance company should usually be taken into account in the determination of the profits and gains of the business.''

and at pp. 619-620:

``But an insurance company, whether a mutual insurance company or not, is undoubtedly carrying on an insurance business and the investment of its funds is as much a part of that business as the collection of the premiums. The purpose of investing the funds of the appellant is to obtain the most effective yield of income. The diminution or increase in the capital value of the investment between the date of purchase and that of maturity, and the apportionment and deduction or addition over the intervening period of that

ATC 4788

diminution from or increase to the interest actually payable on the investment is a material ingredient in the ascertainment of this yield. In Konstam, Law of Income Tax, 8th ed. (1940), p. 126, it is stated that `the buying and selling of investments is a necessity of insurance business; and where an insurance company in the course of its trade realizes an investment at a larger price than was paid for it, the difference is to be reckoned among its profits; conversely any loss is to be deducted.' This view is in line with that of the Privy Council in the case of a bank in
Punjab Co-operative Bank Ltd., Amritsar v. Commissioner of Income-Tax, Lahore (1940) A.C. 1055, at pp. 1072, 1073. In our opinion there is no substantial distinction between the business of an insurance company and that of a bank in this respect. The acquisition of an investment with a view to producing the most effective interest yield is an acquisition with a view to producing a yield of a composite character, the effective yield comprising the actual interest less any diminution or plus any increase in the capital value of the securities.''

The taxpayer submitted that the principles expressed in Colonial Mutual Life Assurance Society Ltd. v. F.C. of T. (supra) were not intended to apply as a general rule to all business of insurance and should be distinguished when the particular business of insurance did not involve any long-term liabilities or actuarially calculated provisions against deferred liabilities and was entirely limited to the writing of ``short-tail'' insurance. In Chamber of Manufactures Insurance Ltd. v. F.C. of T. (supra), the Full Court noted that a business of life insurance may be a special case but still relied upon the statement of principle in Colonial Mutual Life Assurance Society Ltd. v. F.C. of T. as the expression of the usual rule relating to insurance companies (ATC pp. 4318-4319; C.L.R. pp. 603-604).

The reliance upon that statement of principle as expounding a usual rule may be explained by some common characteristics which attach to the conduct of the various forms of insurance and assurance businesses. The operation of the business of an insurer is not limited to the activity of meeting a run of claims in any one year in respect of events against which the insurer has contracted to provide indemnity for loss. The health and continued operation of the business will depend on a wider range of activities. In carrying on the business it would be necessary for the company to achieve demonstrable solvency, not only to meet the requirements of the Insurance Act 1973, but also to provide for a ``commercial catastrophe'', however unexpected that may be. Furthermore, the future health of the business may depend upon adequate reserves in appropriate investments to provide the insurer with the power to be competitive in its business and to operate at an underwriting loss if it is necessary to do so.

The taxpayer relied upon
I.R. Commrs v. The Scottish Automobile and General Insurance Company Limited (1931) 16 T.C. 381 in support of its proposition that gains on realisation of investments made from funds surplus to requirements of a business of general insurance were not of revenue nature. The business of that taxpayer did not extend to life assurance, but did include workmen's and third party risks insurance.

However, in that case their Lordships were required to consider a limited issue raised on a stated case, namely whether the taxpayer/insurer had been engaged in trading in the securities concerned and whether the sales giving rise to the profits were incidents of such trading. The sole question involved in that decision was whether there was an absence of evidence on which the Commissioners could reach the conclusion they had on that issue.

The present case requires consideration of broader issues in determining whether the gains were income according to ordinary usages and concepts.

In the operation of the taxpayer's business in the relevant years of income, there was no determination by the taxpayer that its business had accumulated greater reserves than any foreseeable needs and purposes of the business may have required. The taxpayer was expected to maximise the gains of its business to allow either cheaper insurance to be offered to members of the club or distributions to the club of moneys accumulated by the taxpayer which were excess to the requirements of its business. Therefore, until some other determination was made, the level of funds retained by the taxpayer and not distributed to the club was an assessment by the taxpayer of what funds the

ATC 4789

taxpayer should retain for the purpose of the conduct of its business. The taxpayer took no step to identify any part of its reserve funds as being excess to the requirements of the insurance business, nor did it apply it, or earmark it for application, to the acquisition of some new profit-earning activity or structure to expand the nature and content of its business (see
The National Bank of Australasia Limited v. F.C. of T. 69 ATC 4042; (1969) 118 C.L.R. 529;
Commercial and General Acceptance Limited v. F.C. of T. 77 ATC 4375; (1977) 137 C.L.R. 373). Nor did the taxpayer quarantine any excess funds by investing them in a distinctive manner that showed such funds had been excised from the normal run of investments maintained for the purposes of the business. (See Chamber of Manufactures Insurance Limited v. F.C. of T. at ATC pp. 4318-4319; C.L.R. p. 604.)

By 30 June 1986 the taxpayer had effectively halted the direct growth in the accumulation of reserves by steadily transferring funds on loan to the investment company between 1982 and 1986 and allowing the investment company to derive income and accumulate reserves through the business of investment.

At all times prior to, and during, the relevant years of income, the taxpayer apparently accepted that its investments were part of a necessary reserve for the purposes of its business, and management of those investments was part of the management of the business. The regular replacement of mortgages, bonds, debentures and like securities was part of such management.

With regard to the longstanding investments in shareholdings, the fact that no part of the taxpayer's business involved dealing or trading in shares did not prevent the gains obtained on realisation of such shares being in the nature of income.

The regular switching of such investments may make the income character of the gains more apparent (see London Australia Investment Co. Ltd. v. F.C. of T.) but it is not the only test. As the High Court stated in Colonial Mutual Life Assurance Society Ltd. v. F.C. of T. (at p. 620):

``We can see no distinction in substance between the profit or loss made when an investment is subsequently converted into cash by sale and when it subsequently matures and is paid off.''

The eventual realisation of gains by investments being sold or repaid upon maturity was part of the manner of operation of the business. The gains were sought for the purpose of preserving, or enhancing, the reserves of the business and as such were gains to be treated in the same way as any gain received by payment of a dividend or interest.

The fact that investments may have stood for a number of years did not prevent any eventual gain received being treated as income pursuant to ordinary concepts if the investment had a sufficient nexus with the carrying on or carrying out of a business of insurance. (See
Producers' and Citizens' Co-operative Assurance Company Limited v. F.C. of T. (1956) 95 C.L.R. 26; Australasian Catholic Assurance Company Limited v. F.C. of T.)

Counsel for the applicant argued that the decision of the Full Court in Chamber of Manufactures Insurance Ltd. v. F.C. of T. could be distinguished on the basis that in that case the taxpayer was found to have sold shares in order to have part of the fund more readily accessible to meet contingencies which it actually contemplated in its insurance business - a loss of premium income through cut-throat competition and a possible loss of all workers' compensation business.

The Full Court commented (at ATC p. 4319; C.L.R. p. 604) that:

``The fact that the sales were made with these considerations very much in mind brings them, we believe, clearly within the usual rule relating to insurance companies.''

While it may be said that the fact that the sales in issue in Chamber of Manufactures Insurance Ltd. v. F.C. of T. were clearly made with the purpose of assisting the taxpayer in dealing with difficulties in its insurance business, there is nothing in the decision which supports the proposition that such a purpose must be established before the revenue generated by an insurance company on the sale of its investments can be income for taxation purposes. Where, as in this case, it is not apparent that the taxpayer's sale of its investments were related to immediate and identifiable needs of the company's insurance business, then it is necessary for the Court to

ATC 4790

examine the role of the investments in the taxpayer's business and to conclude whether the sales in issue were acts done in the carrying on of that business. The apparent purpose of those sales will be a relevant, but not necessarily decisive, factor in that process of examination.

The net worth of the taxpayer, mainly allocated to a general reserve, may have been substantially more than was required for the conduct of a business that entailed little or no long-term liabilities and to provide for an adequate margin of solvency and to guard against foreseeable risks, but the fact remained that the taxpayer did not turn its mind to any other steps in relation to the treatment of its accumulated funds. The business of the taxpayer just carried on. In particular, the management of investments and the investment policy effected a continuation of longstanding guidelines set by managerial staff.

The promotion of the investment business of the investment company and the run-down of income-earning activities of the taxpayer's business may have signalled a change in policy being effected by June of 1986, but the realisation of investments in the relevant years of income continued to be acts done by the taxpayer in furtherance of its business of insurance and the conclusion is inescapable that the gains received on such realisations were part of the profits or gains of that business.

It was not the mingling of the realised worth of investments with the income flow that gave any gain resulting from such a realisation the character of income. It was the retention of the investments for the purposes of the business that gave that character to such a gain.

Counsel for the taxpayer argued that the fact that the taxpayer relied in part for its cash flow needs upon dividends and interest said nothing about the characterisation for taxation purposes of gains received from realisations of shares or debentures. Counsel submitted that such gains received by the taxpayer were available to it for any purpose and could be used to purchase capital items, to make further investments or for paying claims. As tracing would be a meaningless exercise, it was argued, no relevant conclusion could be drawn from the details of the cash flow of the applicant which were before the Court. In my view, however, to say that the cash received by the taxpayer could be used for any purpose begs the question as to whether receipts from sale of the taxpayer's investments are to be classified as income as that term is understood in the construction of sec. 25 of the Act. Of more relevance to that classification is the fact that the taxpayer chose not to create any separate fund for its investments, but instead treated its investments as part of a single stream of revenue and expenses that included premium income and claims expenditure. The structure of the taxpayer's affairs suggests that the taxpayer's investment activity was conducted in the course of carrying on its insurance business.

It is now necessary to consider the effect of sec. 23J of the Act on the taxpayer's liability to income tax.

Section 23J reads as follows:

``23J(1) Subject to this section, no part of an amount received by a person upon the sale or redemption of eligible securities purchased or otherwise acquired at a discount on or before 30 June 1982, other than any part of that amount received as accrued interest, shall, for any purpose of this Act, be taken to be income derived by the person.

23J(2) Sub-section (1) does not apply in relation to an amount received by a person by virtue of a transaction that is part of, or is incidental to, the carrying on by the person of a business that includes buying and selling eligible securities of any kind.

23J(3) Sub-section (1) does not affect the operation of section 25A, 26AAA or 26C.

23J(4) In this section, `eligible securities' means -

  • (a) bonds, debentures, stock or other securities; and
  • (b) any other document evidencing or acknowledging the indebtedness of a person, whether or not the debt is secured.''

The section was inserted by the Income Tax Assessment Amendment Act 1982.

The bonds, debentures and semi-government securities realised by the taxpayer in the years of income ending 30 June 1983, 30 June 1984 and 30 June 1985 were all acquired at a discount on or before 30 June 1982 and were

ATC 4791

clearly eligible securities within the meaning of subsec. 23J(4).

In argument it was suggested that the definition of ``eligible securities'' extended to shares by virtue of the use of the term ``stock'' in the definition. In the end nothing turns on the point because the taxpayer did not obtain a gain from the realisation of any shares acquired at discount on or before 30 June 1982. It may be said, however, that the inclusion of shares within the definition set out in subsec. 23J(4) does not sit easily with the terms of the definition and reference to the Treasurer's Second Reading Speech in support of the amending legislation indicates that stock other than shares was in contemplation:

``Earlier this year, the Commissioner of Taxation publicly affirmed the view that profits arising from the sale or redemption at par of securities issued or acquired at a discount are assessable income. It is accepted by the Government, however, that a significant number of small investors had purchased discounted securities in the bona fide belief that the profit on sale or redemption would not be assessable. Indeed, the tap stock prospectus of May this year, which contains no indication that the discount component of the amount receivable on redemption of the stock is assessable income, may have contributed to this belief. Accordingly, it is proposed by this Bill to amend the income tax law to exempt from tax profits made on redemption or sale of any securities acquired at a discount on or before 30 June 1982, other than profits made by traders or dealers and profits to which section 26AAA, section 26C or paragraph 26(a) of the Income Tax Assessment Act applies. The exemption will not affect the tax treatment of profits on the sale or redemption of securities purchased after 30 June 1982.''

  • (Hansard, House of Representatives, 18 August 1982, p. 486.)

The ``tap stock prospectus'', referred to by the Treasurer, is apparently a reference to gilt-edged redeemable government stock usually available on demand. (See The Penguin Business Dictionary (3rd ed.) at p. 287.) It is obvious that the legislation was intended to extend only to securities in the form of securities for indebtedness and the term ``stock and other securities'' was not intended to include a reference to an interest or shareholding in the capital of a company. (See
Handevel Pty. Ltd. v. Comptroller of Stamps (Vic.) 85 ATC 4706 at p. 4718; (1985) 157 C.L.R. 177 at pp. 198-199.)

As has been set out above, the taxpayer did receive amounts upon the redemption of eligible securities which, for the reasons set out above, would have been income derived by the taxpayer unless subsec. 23J(1) applied to exclude such amounts from the income of the taxpayer. The exempting or exclusionary nature of subsec. 23J(1) must apply to all income derived by such transactions of sale or redemption of eligible securities unless the benefit is removed by the specific provisions of subsec. 23J(2) or 23J(3).

The question is, therefore, whether by force of subsec. 23J(2) or 23J(3) the operation of subsec. 23J(1) is so curtailed that it offers no benefit to the taxpayer.

With regard to subsec. 23J(2) it may be said that the amounts received as gains from the redemption of eligible securities were received by virtue of transactions that were incidental to the carrying on of the insurance business of the taxpayer, but it cannot be said that that business of the taxpayer included the buying and selling of such eligible securities in the years of income ending 30 June 1983, 30 June 1984 and 30 June 1985. The conduct of the taxpayer's business of insurance involved investing in eligible securities to be held until redemption as part of a spread of investments retained for the purpose of the taxpayer's business.

No part of that business involved the buying and selling of eligible securities. Subsection 23J(1) makes separate reference to redemption and sale and it would be a strange result to conclude that words of the immediately following subsection, which do not refer to redemption but only to the ``buying and selling'' of eligible securities, were intended to extend to circumstances which contained no element of dealing or trading.

If it was intended that subsec. 23J(2) should catch any income derived by virtue of a transaction incidental to the carrying on of a business, then the final words of the paragraph occurring after the word ``business'' were superfluous.

ATC 4792

The object of sec. 23J was to protect investors who had thought, prior to 30 June 1982, that such investments did not produce assessable income within the meaning of sec. 25 of the Act, but to provide no relief from taxation for gains received by a taxpayer engaged in the business of buying and selling such securities. Subsection 23J(2) was directed at the conduct of a business which included as an element of the business the buying and selling of such securities.

There is a difference between a transaction that is part of, or incidental to, the carrying on of a business and the carrying on of a business possessing a prescribed characteristic. The taxpayer's gains arose from transactions that were incidental to the carrying on of the business of insurance, but not to the carrying on of a business that included dealing or trading in such securities. Therefore, in the taxpayer's case the operation of subsec. 23J(1) was not excluded by subsec. 23J(2).

With regard to subsec. 23J(3), counsel for the taxpayer contended that there was no scope for the operation of sec. 25A or its predecessor sec. 26(a) if, as I have found, the provisions of subsec. 25(1) were applicable to the profits received by the taxpayer.

There is some support for the taxpayer's contention in the comments of Gibbs C.J. and Mason J. in
F.C. of T. v. Whitfords Beach 82 ATC 4031 at pp. 4037-4038; (1982) 150 C.L.R. 353 at pp. 366-367 (Gibbs C.J.) and at ATC pp. 4046-4047; C.L.R. pp. 382-383 (Mason J.) but the decision of the High Court in
F.C. of T. v. The Myer Emporium Limited 87 ATC 4363; (1987) 163 C.L.R. 199 may place some doubt on the proposition. (See
Moana Sand Pty. Ltd. v. F.C. of T. 88 ATC 4897 at p. 4902.)

However, in the present case it is unnecessary for me to undertake any such analysis. As I have set out above, it is clear that neither sec. 26(a) nor 25A can have any application to the facts of this case. The taxpayer did not acquire any of the securities for the purpose of profit-making by sale nor was it carrying out any profit-making undertaking or scheme.

The investments in the securities were made for the purpose of the business of the taxpayer and with a clear intention that such investments were to be held until redemption. They were able to be sold if circumstances demanded it, but were not acquired for the purpose of resale at a profit.

Accordingly, the provisions of subsec. 23J(1) apply and the assessments of taxation for the years of income ending 30 June 1983, 30 June 1984 and 30 June 1985 must be amended by excluding the following amounts from the taxable income of the taxpayer:

  • 1983 $68,478
  • 1984 $123,100
  • 1985 $155,950

The appeals in the matters relating to those years will be allowed and the appeal in relation to the year ending 30 June 1986 will be dismissed.

I will hear submissions from counsel as to costs.


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