Federal Commissioner of Taxation v. Employers' Mutual Indemnity Association Ltd.

Judges:
Hill J

Court:
Federal Court

Judgment date: Judgment handed down 31 August 1990.

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Hill J.

The applicant, the Commissioner of Taxation, appeals against the decision of the Administrative Appeals Tribunal constituted by a Senior Member Mr Roach, allowing in part the objections of the respondent, Employers' Mutual Indemnity Association Ltd., to assessments for the years of income ending 30 June 1985, 1986 and 1987 and reducing the taxable income of those years by $21,985, $402,713 and $487,772 respectively [reported as Case W105, 89 ATC 839].

The amounts by which the assessments were reduced represented the tax on profits derived by the respondent from the sale of certain shares which the Tribunal found to be capital profits and thus not assessable income of the respondent under sec. 25(1) of the Income Tax Assessment Act 1936 (Cth) (``the Act''). It is this conclusion which is disputed by the applicant.

The respondent was incorporated in 1914 as a company limited by guarantee with objects which included the business of insurance and the investment of moneys not immediately required for other purposes. It was formed to enable employer members to conduct mutual insurance and to retain any surplus arising from the mutual insurance activities to members as a rebate from standard tariff premiums. This background aids an understanding of the somewhat special provisions of the articles of association of the respondent and the reference therein to ``sections''.

Originally, membership of the respondent comprised employers who were members of the Master Bakers' Mutual Indemnity Association Ltd. and employers who were members of the Master Plumbers' Indemnity Association Ltd. The articles as originally adopted provided for a division of membership into three sections referred to as the ``A'', ``B'' and ``C'' sections. Membership of the ``B'' and ``C'' sections was restricted to members of the N.S.W. Master Bakers' Association Ltd. and the Master Carriers' Association of N.S.W. respectively. Other members were admitted to the ``A'' section. In 1945 the articles were amended to merge the ``B'' section into the ``A'' section and there were in the relevant years of income only two sections, referred to as the ``A section'' and the ``C section''.

The purpose of dividing the members into sections was to enable premium rates to be set at appropriate levels for the different sections

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ATC 4789

having regard to the industry in which the members were engaged and to allow surpluses emerging from the risks associated with that industry to be related exclusively to participating members.

The articles of association in force at relevant times provided for the business of the respondent to be managed in the two sections by committees elected by the members of the respective section (Art. 9, 11 and 43). Each committee was empowered to determine the different classes of insurance to be undertaken by the particular section and to fix the basis and rate of premium applicable (Art. 12). The general affairs of each section are to be managed by the committee of such section (Art. 46). The company was to have three directors, two of whom were to be the chairmen for the time being of the A and C committees and the third director was to be elected at the annual general meeting each year (Art. 70).

By virtue of Art. 95, profits of each section could be divided between the persons who were members of that section. The committee of each section was to receive, control and deal with all income and receipts arising from or out of the business of the section of which it was the committee (Art. 97). Each section was to maintain a separate bank account under the control of the relevant committee (Art. 99 and 100). In addition, the company was authorised by Art. 101 to operate a third banking account or accounts called the ``general banking accounts'', which accounts were under the control of the directors.

Articles 98, 102-111 provide as follows:

``98. All claims and the expenses of management of each section shall be paid in the first place out of the current year's income and receipts of such section and in case of deficiency such deficiency shall be made good out of the Reserve Account hereinafter described of the section in respect of which such deficiency occurs.

...

102. All moneys paid into or standing in the General Banking Accounts may be drawn out and invested in such manner and upon such securities as the Directors may determine and the moneys represented by such investments together with the amounts standing to the credit of such General Banking Accounts shall be called the General Fund of the Company.

103. All moneys received by each section shall be paid to the credit of a Banking Account of such section.

104. At the end of each year all moneys over and above such as are required to discharge the liabilities of the section at such time and which the Committee of the section intend to distribute by way of rebates to members shall be credited to the General Fund of the Company. In the event of additional moneys at any time being required in the General Fund in order that the Company may have therein sufficient money to fulfil its legal obligations the A and C Committees shall pay to the General Fund such moneys as they shall respectively be called on so to do by the Directors of the Company in anticipation of what may be due to be paid over at the end of the then current year.

105. The Secretary of the Company shall in the books of the Company keep separate accounts one for each section and each such account shall show the amount of money contributed and withdrawn to or from the General Fund by each section and the Account of the A Section in such books shall be called the A Reserve Account and the Account of the C Section in such books shall be called the C Reserve Account.

106. Each section shall be entitled to a refund from time to time from the General Fund of such sum or sums of money as may be required to make up any deficiency as aforesaid but the total amount of such sum or sums so required as aforesaid from the General Fund shall not exceed the amount standing to the credit of such section's Reserve Account.

107. The Secretary shall debit against the Reserve Accounts of the respective sections the amount or amounts of such refunds as aforesaid.

108. The interest and income of the Company derived from its General Fund after debiting the general expenses of the Company not payable by the sections respectively shall immediately prior to the end of each year be paid to the credit of the

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ATC 4790

Reserve Accounts of the respective sections in proportion to the respective credit balances in the Reserve Accounts of the sections at the commencement of such year.

109. The income taxes assessed against the Company shall be paid out of the General Fund and be debited to the Reserve Accounts of the A and C Sections Accounts respectively in proportion to the taxable income of each section.

110. The A and C Committees shall each cause true accounts to be kept of the sums of moneys received and expended by such sections and matters in respect of which such receipt and expenditure take place and of the assets credits and liabilities of such sections.

111. Except as to the accounts to be kept as hereinbefore mentioned the Directors shall cause true accounts to be kept of the sums of moneys received and expended by the Company and the matters in respect of which such receipt and expenditure take place and of the assets credits and liabilities of the Company.''

In the event of the winding up of the respondent, Art. 124 provided that:

``... any surplus moneys or assets of the Company other than such as shall stand to the credit of the Banking Accounts of the sections respectively shall be realised on and paid to the credit of the Banking Accounts of each section in proportion to the credit of the Reserve Account of each section respectively and all moneys then standing to the credit of the Banking Accounts of each section shall be distributed amongst the members of such sections pro rata in accordance with the moneys paid in by them respectively to each section for premiums in accordance with a scheme to be approved of by the Chief Judge in Equity of the Supreme Court of New South Wales or such other Judge of that Court as may have or shall acquire jurisdiction in the matter.''

Meetings of section committees took place in the fourth quarter of each financial year after the accounts for the third quarter were available. At such meetings, each section committee, based on the known results and those projected for the final quarter of the year, determined the amount of rebate of premiums to be allowed to members prior to the close of the financial year in relation to each underwriting class of business. These rebates were provided for in the annual accounts of the section and were deducted from renewal premiums payable by members for the next financial year or paid in cash to policyholders who did not renew and thereby ceased to be members. Provision was then made ``for the expected future cost of all known claims and based on experience for the estimated cost of unreported claims or contingencies'' for policies written in that year. After provision for income tax, and if there was a surplus available, that surplus was then paid into the general fund account.

As the Tribunal found, over the years, the fortunes of the sections fluctuated. For some 25 years prior to 1974 both sections always returned a profit, but there were two years in which section A returned an operating loss ($81,999 in 1980 and $1,159,509 in 1982). In the 10 years from 1979 to 1988 the C section reported operating profits ranging between $10,554 in 1984 to $220,056 in 1982.

Moneys held in the section accounts and surplus to immediate needs were invested and it was accepted that any profits made or losses suffered on the sale or realisation of the assets retained in the section accounts were of an income nature and accordingly included in assessable income or deductible as the case may be.

Surpluses transferred to the general fund were maintained as assets of the sections for the purpose of the separate accounts of the sections and, in accordance with the articles, interest and dividends derived from the investment of the general fund net of the general expenses of the respondent were allocated to the sections in proportion to the respective credit balances of each section at the commencement of a financial year. I shall describe later how the profits and losses on realisation of the assets in the general fund were treated in the accounts.

The investment of the general fund was controlled by the directors of the respondent. For many years prior to 1980 the respondent concentrated on fixed interest investments or preference shares. From the late 1970s the pattern changed and the money in the general

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ATC 4791

fund was increasingly invested in ordinary shares. The Tribunal found the number of investments held in each category to be as follows:

``Year of income          Fixed interest          Preference          Ordinary
ended 30 June            investments              shares             shares
    1981                     70                     81                 24
    1982                     82                     70                 27
    1983                     98                     87                 27
    1984                    100                     37                 27
    1985                     98                     28                 33
    1986                     92                     19                 28
    1987                     64                     12                 22
    1988                     53                     10                 21''
        

The evidence does not reveal the dollar values of the investments in each category over the same period. However the accounts of the general fund for the 1987 year (which include comparative figures for the 1986 year) reveal the following break-up of investments in each category valued at cost for the 1986 and 1987 years:

                                                 1986               1987
                                                   $                  $
Shares/Units in listed companies & trusts     1,628,526.41       1,472,290.91
Shares in other companies                         8,647.47              00.00
Company debentures (listed and unlisted)      1,167,154.64         544,247.97
Governments & other public securities (listed 1,816,410.73       3,501,590.18
& unlisted)
Bank deposits                                   678,364.15           5,036.45
Loans secured by mortgage                       114,566.13           1,566.13
                                             -------------      -------------
                                             $5,413,669.53      $5,524,731.64
                                             -------------      -------------
      

The Tribunal, which accepted the evidence of Mr Gluskie, the secretary of the respondent, found that the selection criteria used by the directors in the management of the general fund involved the following considerations:

``• Investments (whether shares or fixed interest securities) which were likely to realise less than their cost were to be avoided;

• Investments (whether shares or fixed interest securities) with the prospect of an increase in value were to be preferred;

• Investments not likely to reliably and regularly produce substantial returns by way of dividend, or interest, or surpluses upon maturity were to be avoided;

• Shares likely to produce dividends at increased rates were to be preferred;

• Shares likely to produce increased dividends were likely to increase in value;

• Shares likely to increase in value were to be preferred to those which would not be likely to so increase.''

It was further found that ``more probably than not, no share under consideration was acquired with the expectation that, upon it realising an expected or hoped for increase in market value, the increased value would be realised by sale''.

Evidence was given by Mr Gluskie as to the circumstances surrounding the sale of the various securities in the general fund in the years of income which gave rise to the net profit treated as assessable income by the applicant in those years. It is not necessary to detail this evidence, save that, in many cases at least, shares were sold as a result of take-over offers and a change in control of the companies but in other cases it would seem that sales were brought about by a reassessment of the

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ATC 4792

prospects of the companies, or by a reduction in dividends emanating from the companies.

Some of the sales of assets in the general fund occurred within 12 months of their acquisition so that the profits made were assessable under sec. 26AAA of the Act and are not included in the amounts in dispute. One such sale, effected after a take-over was proposed, realised a profit of $130,277 for the sale of a parcel of 40,000 shares in one company. Notwithstanding, the Tribunal was of the view that these shares were not acquired for any dominant purpose of profit-making by sale.

It should perhaps here be mentioned that the Tribunal found that ``situations had arisen in which the sections had suffered loss years'' (that was not in dispute) and further that this ``had necessitated them drawing in substantial amounts upon the credits held in their reserve accounts with the General Fund''. This latter finding was challenged in a notice of contention by the respondent as being against the weight of the evidence, as indeed it was. The evidence, which was unchallenged, was that in only one year, the 1980 year, did either section have recourse to the assets of the general fund and that was when the A section had transferred to it what Mr Gluskie referred to as a ``small sum''. There was no evidence as to the quantum of any amount so paid. There was in the 1982 year, despite a loss in the A section, apparently no need to actually transfer cash from the general fund.

The Tribunal also found (at p. 849), and part of this finding was again challenged by the respondent in a notice of contention, that:

``On the other hand I am satisfied that although care was taken - not always successfully - to choose investments likely to at least maintain and to preferably rise in value, that objective was subordinate to the desire to achieve a substantial, reliable and regular income flow. In doing so it sought to hold assets in a form and with a value acceptable to both the company and to the Insurance Commissioner as providing sufficient reserves to enable the company to discharge any liabilities which might arise under policies of insurance it had issued.''

The reference to the Insurance Commissioner's requirement is a reference to the provisions of the Insurance Act 1973 (Cth) regulating the business of the respondent which was licensed under it to carry on insurance business. Under that Act and the Regulations made thereunder, the respondent was required to maintain a solvency margin calculated by taking into account the reserves of the respondent represented by the investments of its insurance business. There was no dispute that the assets in the general fund as well as the assets in the two sections' funds were taken into account in calculating this ratio.

The Tribunal's finding in the second sentence of the passage quoted is arguably ambiguous. Counsel for the respondent contended that what was meant by it was that in choosing to invest the assets of the general fund, the respondent sought to hold assets in a form which would satisfy the Insurance Commissioner's solvency requirement to have a sufficient reserve in accordance with the formula in the Insurance Act and Regulations. It was argued that the Tribunal did not find or alternatively there was no evidence upon which the Tribunal could find that by investing in the general fund the company sought to hold assets in a form and with a value acceptable to it as providing sufficient reserves to discharge potential liabilities.

There was little evidence directed to the matter. In his affidavit, Mr Gluskie made passing reference to the requirements of the Insurance Commissioner. He deposed that the calculation of the amount to be transferred from a section to the general fund was made ``after provision has been made for the expected future cost of all known claims and further provision has been made, based on experience, for the estimated cost of unreported claims and contingencies''. In cross-examination he repeated this evidence. He said:

``... what is left over [i.e. after provision for claims in the future, including any claims inflated by circumstances] is money that they regard as surplus to their insurance requirements...''

Earlier Mr Gluskie was asked in effect whether one reason for the investment in the general fund was ``that it was desirable to have a reserve fund available against calamitous circumstances such as the failure of the investment of the section's funds or a period in which there were an abnormally large number

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ATC 4793

of claims?'' To this question Mr Gluskie replied:

``No, I do not think that was a consideration at all. I think that when you talk about calamitous claims, the claims occur during the year, so the company knows what those claims are, the premium rates are set by the government, adequate reinsurance policies were held. There was never any feeling that there was any need to provide for capital in calamitous circumstances, what was considered to be necessary was to have a guarantee fund that would provide the requirement for any solvency margin in relation to the insurance business that was conducted by the section.''

The cross-examination continued:

``I think what you have said to me is that certainly one reason for the keeping of these moneys in investment through the general fund was to satisfy the solvency requirements of originally the State then the Commonwealth under one form and now the Commonwealth under a new form? - I guess we see the solvency requirement, as you call it, as being a solvency margin, a guarantee fund. The structure of it is a quantum of money which has a relationship to premium income and, yes, as the association's premium income grew it would be necessary, particularly with the increase from 15 per cent to 20 per cent of premium income in the solvency margin whenever it occurred, `73 or `78, a larger amount of money was required to be held in the general fund.''

It seems clear that what was understood by the cross-examiner was that Mr Gluskie's answer related to the solvency requirement of the Insurance Commissioner rather than to a view of the respondent as to the necessity of investing the common funds to provide a reserve to meet the anticipated liabilities of the insurance business. Indeed it is difficult to see how the evidence could be read otherwise.

With respect to the first limb of the submission, it is difficult as a matter of language to treat the Tribunal's finding as limited only to the need to comply with the requirements of the Insurance Commissioner. The finding seems quite unambiguous in its terms. In addition to the oral evidence set out above, there must also be considered the terms of the articles of association which provided the legal framework pursuant to which the allocation of funds from the sections to the general fund was required to be made.

The articles make it clear that what is to be provided for by each section prior to the allocation to the general fund are the liabilities of the section at such time i.e. at the time of allocation. It is arguable that future liabilities (which may be merely contingent at the time of allocation) need not be provided for. But whether or not the article is to be so construed, the framework of the articles contemplates that the moneys in the general fund and the investments representing those moneys, will be available to meet the insurance commitments of the respondent. While it is true, as Art. 98 makes clear, that claims are to be paid out of current year's income, where that is inadequate (i.e. where there is a deficiency) that deficiency is to be made good out of the reserve account. That reserve account includes, as Art. 105 provides, the contribution made to the general fund as well as the proportionate share of the interest and income derived from the investments in the general fund (Art. 108).

Save as to Art. 124 which deals with the reallocation of surplus moneys in the general fund to the section accounts in the event of liquidation, the articles are silent as to what is to happen to profits and losses on sale of the assets of the general fund (unless the profits are ``income'' within the contemplation of Art. 108). However, the common-sense view of the matter is that, as the investments representing each section's contributions to the general fund were assets of the section making the contribution, so accretions to those assets were also for the benefit of that section and losses made were equally to be debited to the section.

This was the course in fact adopted in the accounts. Thus in the balance sheet of the general fund for the year ended 30 June 1987 the value of the investments of the C section is shown as $2,065,995.66. A separate item, which includes the result of profits on sale or redemption of fixed interest securities purchased at a discount in the accounts is referred to as the Investment Fluctuation Reserve C and amounted to $512,336.63. These two items total $2,578,332.29 being the figure taken up in the accounts of the C section in the balance sheet of that section for the same

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ATC 4794

year under the heading ``Current Assets'' - general fund.

While on the subject of the C section balance sheet it may be noted that under the heading ``Current Liabilities'', ``Outstanding Claims Provision less Reinsurers' Liability'' is shown in the same year the amount $6,061,048. Total current liabilities appear in the same account as $6,809,657.34. As the balance sheet shows only an excess of assets over liabilities of $2,380,436.32 in that year it is obvious that if assets stand in the accounts at current values, resort must be had to the assets in the general fund, at least in part to provide for the insurance liabilities. So far as I can see, no attempt was made to explore in evidence the assumptions upon which the balance sheets of the sections were prepared so I would not place any weight on the balance sheets.

Another aspect of the evidence which is relevant in considering the Tribunal's finding is the cross-examination of Mr Gluskie concerning the purpose of having investments in the general fund. This cross-examination was in the following terms:

``Is it not correct to say that one of the purposes of the investments of surpluses in the general fund is to provide a reserve against future claims? - No.

Well then what is the purpose of paying the money into the general fund rather than making it available to policy holders by way of rebate? - I thought I had said something in relation to that earlier.

I think you did; I just want to ask you the question? - The committees - the directors of the company considered that they required to have a larger sum of capital available to carry on the objects of the company.

Well, does that mean that they wanted a larger sum of capital available, at least in part, for the purpose of providing a reserve against future claims? - No, because all claims had been provided for by the members. What they needed was to have a larger guarantee fund to enable the solvency margin that the Insurance Commissioner required to be available for an increasingly [sic] level of premium business.

Would you agree then that one of the reasons was that it was necessary, at least in part, to provide a statutory reserve against future claims? - No, I do not see it, that that statutory reserve is described in that way.''

After a number of questions as to the witness' opinion as to the purpose of the statutory fund the witness continued:

``The Insurance Commissioner has a solvency margin requirement in order to grant a licence. The directors of the company saw it as necessary to have their own net assets at a level which would satisfy that solvency requirement, but that does not mean that they had to describe it as a statutory reserve, to them it was their capital, their surplus capital over and above their assets that were necessary to meet insurance liabilities.

Perhaps the two aspects I was trying to isolate are part of the one. Is this the situation, that because of the solvency margin requirements of the Insurance Commissioner, as you understand it, the company formed the view that it was desirable to keep a larger capital investment because that was necessary to satisfy the Insurance Commissioner? - That was one of the reasons, yes.

Is there any other reason? - Other reasons would be the desire to provide other facilities and benefits for members, and consideration has been given from time to time to undertaking other activities.

How, may I ask, would the accumulation of a capital fund in your understanding provide for that proposal? - It obviously is a far-sighted idea of perhaps doing something else for members, conducting some other business activity such as other forms of insurance, other activities such as health care, rehabilitation services, associated activities.''

Later the witness conceded that apart from ancillary services there were no concrete plans for other activities. The witness ultimately accepted that a useful by-product of the investment of surpluses in the general fund was the earning of income for the sections, that income permitting a reduction of premiums or the provision of rebates for the benefit of members and that part of the purpose of the investment in the general fund was to earn

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ATC 4795

income on the investments for the purpose of reducing premiums or providing rebates.

The significance of the cross-examination is in part, in any event, that the moneys in the general fund were not applied to some purpose which might be clearly identified as a capital transaction but rather, as the articles of the respondent suggested, the investments representing the general fund were a source of funds should it turn out that the calculations of liabilities made by each section committee were inadequate as well and in the meantime were producing income which could be used to reduce premiums or increase rebates to members. They also provided a means of investment of funds which were necessary to be kept in some form as assets to satisfy the Insurance Commissioner's solvency requirements.

The Tribunal's finding was, in my opinion, inadequately expressed in the light of the evidence, although at the end of the day, even if there were an error of law in making it, I do not think that it makes any difference to the outcome of the appeal. Assuming that the Tribunal accepted the oral evidence given (and this would seem to be so) the finding might have been more carefully expressed in the following terms:

``In doing so it sought to hold assets in a form and with a value acceptable to both the company and to the Insurance Commissioner as providing, for the purposes of the requirements of the Insurance Commissioner under the Insurance Act sufficient reserves to enable the company to discharge any liabilities which might arise under policies of insurance it had issued, although the members of the section committees had sought before determining each section's contributions to the general fund to provide for the estimated liabilities of the respective section and did not believe that resort to the general fund would be necessary.''

I propose to determine the case having regard to my reformulation of the finding, which is more favourable to the respondent than that expressed by the Tribunal. I should say that it would make no difference to the outcome of the case if the Tribunal's finding were allowed to stand.

One further matter remains to be noted. At the time of the initial formation of the respondent, its business comprised only workers compensation and public liability insurance. From 1933, motor vehicle comprehensive and third party insurance was written but in 1980 third party motor vehicle loss insurance was discontinued and in February 1982 the respondent ceased to write comprehensive motor vehicle insurance. Both workers compensation insurance and public liability insurance are essentially long-tailed insurance, that is to say that claims under policies or the quantification of those claims may not emerge for a considerable time after the year in which the policy premium is paid, so that it would be necessary to provide for the liability using an actuarial basis of calculation.

The decision appealed against

The Tribunal, having rejected on the facts a submission that the profits on share sales were profits from the realisation of assets purchased for the dominant purpose of resale at a profit falling within sec. 25A of the Act considered the question whether the profits were income in ordinary concepts.

Before the Tribunal, as indeed before this Court, it was submitted that the case fell within the general principle stated in
Colonial Mutual Life Assurance Society Ltd. v. F.C. of T. (1946) 73 C.L.R. 604 at p. 618 that:

``... 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.''

Alternatively it was submitted that the case fell within the principles enunciated in
London Australia Investment Co. Ltd. v. F.C. of T. 77 ATC 4398; (1976-1977) 138 C.L.R. 106, in that the profits were a part of a business of investment.

The Tribunal held that the profits arising from the holding to maturity of fixed interest securities constituted assessable income under sec. 25(1) of the Act and the respondent did not cross-appeal against that decision. However, the Tribunal was of the view that the profits on the sale of the shares were of a capital nature and did not form part of assessable income.

The process of reasoning of the Tribunal is open to the criticism that it was difficult to

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ATC 4796

know the precise foundation for the Tribunal's conclusion. This is because the Tribunal indicated that the relevant principles had been considered in Case W6
89 ATC 147 and without much elaboration purported to apply them. The difficulty, however, arises from the fact that the Tribunal in Case W6 found the applicant insurance company was assessable on the facts of that case so the reasons why the respondent in the present case was not assessable have to be in part found by inference.

However it would seem that the Tribunal reached its conclusions, so far as the first submission is concerned, largely because of the separation of the activities of the sections from that of the general fund. Thus in para. 37 of its reasons the Tribunal said:

``I also take into account the circumstance that, in so far as it could be done within the structure of a single legal entity, a clearly defined line of demarcation was established between the management of, and the investments of, the general fund and of the sections. Certainly, in my view, the applicant is not to be held liable only for lack of any such clear distinction between its trading insurance investments and its capital investments.''

Accordingly, the Tribunal regarded it as appropriate to treat the general fund as if it were ``the only activity of a separate legal entity seised of substantial moneys which it wished to invest at a profit, without engaging in any trade or business activity beyond that involved in maintaining its investment portfolio''. The Tribunal took into account that the directors had substantial funds available for investment and expressed the view that any significance to be attached to the number of transactions should be discounted. The Tribunal said (at p. 849):

``The circumstance that a portfolio involves a wide spread of investments will always be likely to generate an increased number of transactions without thereby indicating a pattern of buying and selling indicative of the investor being in any business of dealing in such investments or of having undertaken any particular investment for the dominant purpose of profit-making by sale.''

The Tribunal then posed the question for decision as being:

``The question is whether the scale of the activities of App-co is such as to bring the profits derived on the occasion of the sale from time to time of some investments into calculation as assessable income. Whether the nature and scale of such activities as it engaged in gives rise to a revenue character in the transactions involves question of fact and degree.''

The law

It is not unusual for reference to be made in submission by counsel and in discussions of the relevant law to the insurance or banking cases hereafter discussed as if they constituted a discrete body of law to be applied.

It is the genius of the common law that a case-by-case examination produces a flexible legal system. It may, however, be a valid criticism of the gradual evolution of the law in this manner that what is but the application of fundamental principle to the facts of a case comes to be seen as a separate statement of principle, taking on its own life; as a new limb engrafted upon the tree of legal principle. Such in my view is the case with the so-called ``banking and insurance'' cases.

The basic principle to be applied is that expressed in the well-known passage from the opinion of the Lord Justice Clerk in
Californian Copper Syndicate Limited & Reduced v. Harris (1904) 5 T.C. 159 at pp. 165-166 distinguishing between the mere realisation of a capital asset where the gain or loss will be a gain or loss of capital and those occasions where the gain or loss will be on revenue account. ``Delphic'' although the passage may be (cf. London Australia (supra) per Barwick C.J. at ATC p. 4401; C.L.R. 112) it provides some insight into the difficult distinction between income and capital gains where securities are realised.

In Californian Copper, the Right Honourable J.H.A. Macdonald said:

``... it is equally well established that 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.''

His Lordship then went on to express the distinction as follows:

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ATC 4797

``Is the sum of gain that has been made a mere enhancement of value by realising a security, or is it a gain made in an operation of business in carrying out a scheme of profit-making?''

A matter of significance in stating the test in these terms is that it requires close attention to be given to defining the business activities of a taxpayer or as was said in
Western Gold Mines N.L. v. Commr of Taxation (W.A.) (1938) 59 C.L.R. 729 at p. 740 quoted by Gibbs J. in London Australia (supra) at ATC p. 4403; C.L.R. p. 116 it is necessary ``to make both a wide survey and an exact scrutiny of the taxpayer's activities''.

Where the sale of securities is an act done in what is truly the carrying on of a banking business the profits on sale will be income of that business:
Commr of Taxation v. Commercial Banking Co. of Sydney (1927) 27 S.R. (N.S.W.) 231 at pp. 233-234;
Punjab Co-operative Bank Ltd. Amritsar v. Commr of Income Tax, Lahore (1940) A.C. 1055 and as these cases make clear, it was not necessary to this conclusion that the taxpayer carry on a separate business of buying and selling investments with a view to profit.

The explanation for this result is that the ordinary business of banking consists in dealing with money and credit, receiving money on deposit with or without interest and lending these amounts out to borrowers at a higher rate of interest. The business of banking requires that the banker keep enough funds in cash or easily realisable securities to meet any probable demand by depositors: Punjab Co-operative at pp. 1,072-1,073. Thus, if such securities are realised, that realisation is, in the words of their Lordships in that case, ``a normal step in carrying on the banking business, or, in other words,... it is an act done in `what is truly the carrying on' of the banking business'' (p. 1,073). The money of the bank is in such cases analogous to its stock in trade.

As explained in
Union Bank of Australia v. Commr of Taxes (1920) N.Z.L.R. 649, cited with approval in Commercial Banking Co. of Sydney (supra) at p. 235:

``In order to carry on such a business properly, it is necessary to have a large reserve fund. This fund is created out of profits, and is invested so as to be available immediately for meeting demands on the bank as they may arise. It is not treated as part of the capital of the bank, and the investments cannot be regarded as investments of capital. They are a use of profits for the purposes of the business of banking when conducted in the recognised and proper manner. The realization from time to time of these investments appears to be part of the ordinary business of a banker, just as much as the realization of a security given by a customer in connection with an advance.''

It is hardly surprising that when the issue arose whether the realisation of investments of a life insurance company was an activity which was part of the ordinary business of such a company, it was held that it was and that the proceeds of realisation produced profits or losses on revenue account. Colonial Mutual Life Assurance Society Ltd. v. F.C. of T. (1946) 73 C.L.R. 604 at pp. 607-608 and pp. 614-618;
Producers' & Citizens' Co-operative Assurance Co. Ltd. v. F.C. of T. (1956) 95 C.L.R. 26 at pp. 32-34 and
Australasian Catholic Assurance Co. Ltd. v. F.C. of T. (1959) 100 C.L.R. 502 at pp. 505-509.

In the Colonial Mutual case, Starke J. at p. 608 stated the issue to be determined in the following way:

``The intention of a taxpayer cannot be considered as determining what it is that his acts amount to; and the real thing that has to be decided is what were the acts that were done in connection with the business and whether they amount to a trading which would cause the profits that accrued to be profits arising from a trade or business...''

As the judgment of the Full Court (Latham C.J., Dixon and Williams JJ.) pointed out at pp. 615-616, the expenses and other contingencies of a life insurer must be met by the investment of its funds and the investing of its funds is part of the business of that insurer. So it will be that the profits of realisation of such investments will usually be on revenue account. A similar conclusion had been reached in the United Kingdom with respect to life insurance companies in, for example,
Liverpool & London & Globe Insurance Co. v. Bennett (1913) A.C. 610; and
Northern Assurance Co. v. Russell (1889) 2 Tax Cas. 571. Accordingly, the Full Court concluded in the Colonial Mutual Life case at p. 620:

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ATC 4798

``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. Such an acquisition and subsequent realization is a normal step in carrying on the insurance business, or in other words an act done in what is truly the carrying on of the business of the society.''

Nor will the mere fact that the investment is not in shares ordinarily necessitate a different conclusion. In Colonial Mutual the Court was concerned with shares; in Producers' & Citizens' with investment in freeholds. Provided the realisation is ``sufficiently related to the... business of life assurance'' the profits will be brought to tax (see Producers' & Citizens' at p. 34). Australasian Catholic Assurance was also concerned with the realisation of blocks of flats.

It appears to have been thought that a different conclusion would flow if the taxpayer carried on not the business of a life insurer but a business of general insurance and that the decisions so far cited which in my opinion all stemmed from conclusions of fact and the application of well-established principles to the factual circumstances under consideration, could not apply to a general insurer. That view was dispelled in Australia by the discussion of this Court in
Chamber of Manufactures Insurance Ltd. v. F.C. of T. 84 ATC 4315; (1984) 2 F.C.R. 455 where it was held that the profits on realisation by a general insurer were on the facts of that case income in ordinary concepts being part of the ordinary insurance business of the appellant insurer. More recently, the case has been followed and the same conclusion reached in
R.A.C. Insurance Pty. Ltd. v. F.C. of T. 90 ATC 4737.

In the course of the Full Court's judgment in the Chamber of Manufactures' case, the Court (Bowen C.J., Woodward and Northrop JJ.) after referring to the comment in the Colonial Mutual case cited earlier to the effect that profits and losses on the realisation 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, continued at ATC p. 4318; F.C.R. p. 459:

``It should be noted that this view was expressed in terms which would cover all insurance companies, although its emphasis may have been affected by the fact that the company there in question was a life insurance company. The business of life insurance obviously is a special case because of the necessity to maintain an actuarial relationship between accumulated funds and liabilities, and to obtain a regular yield from investments with surplus funds typically being distributed to policy holders in the form of bonuses.''

The appellant in that case was an insurance company 70% of the business of which was in workers compensation. It had been found as a fact that the investments had an important bearing on the profitability of the appellant, that they were available to meet the claims of policyholders, that they were readily realisable to meet claims and that they constituted a reserve fund for the payment of claims whatever the board may have intended.

At first instance it had been found that the board intended that the securities realised should serve as a reserve fund. This last finding which the Full Court described as ``not essential to the judgment'' (it is unclear whether that comment related to the judgment at first instance or upon appeal) was challenged unsuccessfully on appeal.

In the circumstances before the Court, the shares had been realised 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'' (ATC p. 4319; F.C.R. p. 460).

The Court concluded:

``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.''

The facts in the R.A.C. case may be thought to have been more favourable to the taxpayer. The taxpayer conducted what was described by Lee J. at first instance as principally ``short-tail

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ATC 4799

insurance''. It did not carry on workers compensation business. There was no finding that the shares in question were realised for the purpose of providing a fund to meet contingencies as there had been in Chamber of Manufactures. Nevertheless it was found as a fact at first instance, and this was apparently not disputed, that the securities in question were purchased to ``represent a safe holding for part of the reserves of the taxpayer's business''. This finding was made notwithstanding that the company conducted its business in such a way that it was the 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''.

It was held that the investment in the shares was simply an overall part of the investment of the insurance reserve and was an ordinary part of the appellant's insurance business activity.

In reaching this conclusion the Court placed some weight upon the reference in the judgment of Jacobs J. in the London Australia Investment case to the consequence that the investments were made out of circulating capital. In the last-mentioned case Jacobs J. had said at ATC pp. 4410-4411; C.L.R. pp. 129-130:

``The nature of a banking or insurance business, as part of its putting of money as circulating capital to use, involves not only occasional acquisition of property in satisfaction of advances, as in the situation to which Kitto J. was referring, but also and more commonly the purchase and sale of various kinds of property whereby moneys which are obtained as part of the business but which form no part of the original capital structure of the bank or insurance company, or of that structure enhanced by accumulated net profits, are put to use short term or long term. All profits arising from that activity are profits of the business of banking or insurance. At any time and from time to time the property acquired may need to be sold, in whole or in part, to meet the requirements of the banking or insurance business and the hope and expectation is that in the meantime not only will the property have earned income but that it will have risen in value. The scale of activity coupled with the source of the funds leads to the inference that a purpose or intention of the acquisition is eventual resale at a profit. But in so far as the original capital or that capital enhanced by accumulated profits is laid out in investments in property and not in the business activity of banking or insurance, the investments will have the character of capital and profits or losses on a sale thereof will not be profits of the business of banking or insurance.''

Thus in the R.A.C. case their Honours said at p. 4742:

``As with companies carrying on a business of life assurance, R.A.C. Insurance received premiums in advance of the insured event occurring. As part of its business, it invested those funds with the intent of gaining a return thereon. Such a return, whether interest, dividend or profit on sale, formed a part of the profits of the insurance business and arose from the investment of its circulating capital, the premiums received, which were reflected in the insurance reserve.''

There may be thought to be some reluctance on the part of lawyers to embrace an economist's concept of ``circulating capital'', cf. the comment of Jenkins L.J. in
Reynolds & Gibson v. Crompton (1950) 33 T.C. 288 at p. 303 that the distinction between fixed and circulating capital was ``debatable'' referred to by Mason J. in
Commercial & General Acceptance Ltd. v. F.C. of T. 77 ATC 4375 at p. 4381; (1976-1977) 137 C.L.R. 373 at p. 383. However the notion of circulating capital does perhaps provide some assistance in a case where the assets in question represent the funds with which the taxpayer trades where the business is one of turning over money.

It has, however, never been suggested that all proceeds of realisation of a bank or insurance company are on revenue account. There will be cases where a bank may utilise funds to take over another banking business where the circumstances will show that the asset in question is a capital asset such that the subsequent realisation of it will produce a capital profit:
National Bank of Australasia Ltd. v. F.C. of T. 69 ATC 4042; (1968-1969) 118 C.L.R. 529. So too, as the Full Court observed

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ATC 4800

in the Chamber of Manufactures case (supra) at ATC p. 4318; F.C.R. p. 460:

``... funds of an insurance company invested in the construction of a building to be used as a head office by that company will probably not attract income tax if the head office is subsequently sold for a profit.''

In such cases the objective facts as to the use of the funds of the bank or insurance company will show that the funds have not been invested in the ordinary course of investment of the taxpayer as part of the banking or insurance business but as a capital asset.

In the course of the judgment in the Chamber of Manufactures case, the Full Court commented at ATC pp. 4318-4319; F.C.R. p. 460:

``Even in a case such as the present, the position might have been different had the taxpayer maintained two quite separate funds - the first acknowledged as a reserve fund and demonstrably sufficient to meet claims and expenses in all reasonably foreseeable contingencies - the second categorised and dealt with as an investment fund. Whether profits from the sale of investments in the second fund were taxable would depend upon factors unrelated to insurance such as those referred to in the London Australia Investment Co. case.''

It was this passage upon which the respondent sought to rely in the present case to distinguish it from the Chamber of Manufactures case. It was submitted that while the assets of the respondent were all available to meet the claims of creditors, the respondent had maintained separate funds, the first, segregated into the A section fund and the C section fund was, it was submitted, acknowledged as a reserve fund; the second, the general fund was, it was submitted, acknowledged as an investment fund, so that unless the activities of investment in the general fund were such as to amount to a separate investment business, the proceeds of realisation should be seen to be on capital account.

The appellant in the Chamber of Manufactures case failed because it was unable to satisfy the onus of proof that it had maintained two separate funds, as there was no real distinction between the assets said to constitute the ``hard core'' of assets said to be readily realisable from the assets in question which were largely public company shares and fixed interest securities. A possible difference in transactions involving particular shares was not explored. It was in this context that the Court referred to the circumstance that there was no documentary support for any distinction between the two funds which was said to exist. While the absence of documentary evidence might not be fatal if there were other evidence which could support a separation of assets into revenue and capital assets, a taxpayer which is able to rely on such documentary evidence will no doubt find it easier to satisfy the onus placed on it by sec. 190(b) of the Act.

In the present case there is a documentary division of funds. The question is whether the evidence justifies the conclusion that the section funds (seen as one fund for this purpose) were acknowledged by the respondent as the reserve fund of the respondent and, if it be a separate matter, whether they were ``demonstrably sufficient to meet claims and expenses in all reasonably foreseeable contingencies''.

The part to be played, in resolving the present question, by the subjective intention of the directors is one of some difficulty. The evidence of subjective intention was to the effect that the general fund was not seen by the directors as a reserve fund because all reasonable contingencies had been provided for by the section funds. The articles, representing the legal framework for the decision-making process are not wholly consistent with this oral evidence in two respects. First, the computation of the amount to be contributed by a section fund to the general fund (and a fortiori the amount to be retained in the section fund) proceeds upon the basis that it is only liabilities existing at the date of calculation that are provided for. By inference, contingent liabilities may not be. This is of little significance in itself. Of far greater significance, however, is the mechanism which the articles provide for claims to be made against the general fund to provide for an excess of liabilities in the section funds. Put briefly, the articles suggest that the general fund is not to be seen purely as an investment fund and that the general fund has not lost its character as a reserve fund.

Whatever significance may be placed upon the evidence of subjective intention in other

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ATC 4801

cases, it seems to me that the present is a case where that evidence, if conflicting with the articles, must play a subordinate place in the determination of the question whether the assets in the general fund have ceased to be part of the ordinary insurance reserve.

In the present case there is, however, another factor of considerable significance. Not only do the articles of association envisage the possibility of there being claims against the general fund by each of the sections, but also as a matter of fact such a claim was made in the 1980 year. This raises an issue whether the section funds, if seen together as the reserve fund, were ``demonstrably sufficient'' to meet claims and expenses in all reasonably foreseeable contingencies. I should say that the respondent did not seek to advance evidence suggesting that there was some unforeseen circumstance which led to the 1980 loss. So far as the evidence suggests, the loss was an ordinary trading loss and hence, presumably foreseeable.

One measure of the adequacy of a reserve fund is the statutory criterion adopted by the Insurance Commissioner in requiring an insurer to maintain assets sufficient to satisfy the Commissioner's solvency ratio. It is not in dispute here that the assets in the section funds standing alone would not have satisfied that ratio and that for the respondent to satisfy the Insurance Commissioner's requirement, resort had to be made to the assets in the general fund. No doubt the Insurance Commissioner's tests are not determinative and it would be open to a taxpayer to call expert evidence in a particular case in regard to a particular business to show that the statutory requirements are excessive. However, where the respondent's own experience has shown need to resort to the assets of the general fund and where the statutory requirement suggests a reserve fund greater than the section funds needed to be maintained, it is difficult, particularly in the light of the articles of association, to see the general fund in this case as being other than a part of the ordinary insurance reserves of the respondent, the investment of which (pending the need to resort to them to meet claims) is part of the ordinary insurance business of the respondent. There is, in my view, a sufficient nexus between the realisation of the assets by the respondent and its insurance business to require the conclusion that the net profits from realisation are income in ordinary concepts.

In these circumstances there is no need to consider the applicant's second submission, namely whether on the evidence the company could be said to have carried on a separate investment business; cf.
CMI Services Pty. Ltd. v. F.C. of T. 90 ATC 4428 where such a submission succeeded, with
F.C. of T. v. Equitable Life & General Insurance Co. Ltd.; Equitable Life & General Insurance Co. Ltd. v. F.C. of T. 90 ATC 4438 where it failed. A third challenge to the Tribunal's conclusion wherein it was suggested that the Tribunal had reversed the onus of proof in concluding that the shares were not purchased for resale at a profit had no substance and I reject it.

I would accordingly allow the appeal and order the respondent to pay the Commissioner's costs.

THE COURT ORDERS THAT:

1. The appeal be allowed.

2. The respondent pay the applicant's costs of the proceedings.