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17 Dec 2013
Appeal Status

Sovereign's appeal dismissed by the Court of Appeal

2013 case note - Court of Appeal dismissed Sovereign's appeal of income tax assessments for the 2000–06 income years - accrual rules, capital/revenue distinction.

Sovereign Assurance Company Limited v Commissioner of Inland Revenue


The Court of Appeal dismissed Sovereign Assurance Company Limited's ("Sovereign") appeal of its income tax assessments for the 2000–06 income years. The Commissioner of Inland Revenue ("the Commissioner") reassessed Sovereign in accordance with the accrual regime on the basis that the refundable commission transactions under the treaties were a financial arrangement pursuant to subpart EH of the Income Tax Act 1994 ("the Act").

Impact of decision

This decision reinforces the Court's acceptance of the primacy of the accrual rules over other provisions in the Income Tax Acts. It also provides (obiter) discussion on the capital/revenue distinction by the Court of Appeal.


This appeal relates to the tax treatment of cash flows arising under certain reinsurance treaties entered into between Sovereign and a number of German reinsurance companies. By agreement, the treaty between Gerling-Konzern Glonale ("Gerling") and Sovereign was accepted as being representative of the treaties with the other German reinsurance companies (Hanover Re and Cologne Re ).

The treaties provided for two money flows between Sovereign and Gerling:

  1. a premium paid by Sovereign to Gerling to reinsure a defined portion of the life insurance policies issued by Sovereign. In return, Gerling assumed liability to make payment of a defined portion of any claim that was subsequently made (referred to as the "mortality risk"); and
  2. the commission paid by Gerling to Sovereign (quantified as a multiple of the initial premium received by Sovereign on new policies).

Sovereign then made "commission repayments" to Gerling, in defined portions, out of subsequent years premiums for as long as those policies remained in force. Sovereign was not required to pay these "refundable commissions" if any individual policy lapsed. (This description of the money flows was that used by the Commissioner and the Courts rather than by Sovereign and the German Reinsurers themselves, see [72].) However, there were overall arrangements between Sovereign and Gerling as moderated by a bonus account. The bonus account kept track of total money flows in both directions with an ultimate purpose of enabling the calculation of any profit share to which Sovereign would become entitled if the bonus account went into credit after the reinsurer was fully repaid.

Sovereign accounted for those money flows by returning the refundable commissions as assessable income when they were received from Gerling and then deducting the commission repayments (being the base component received from Gerling plus the interest component) as a deductible expense when paid to Gerling. Sovereign's position was that the money flows were components of a contract of insurance that could not be "unbundled" and in their entirety were an excepted financial arrangement.

The Commissioner had reassessed Sovereign in accordance with the accrual regime on the basis that the refundable commission transactions under the treaties were a financial arrangement pursuant to the Act.

In the High Court, Dobson J agreed with the Commissioner that these four flows of money under the treaties could be "unbundled" for tax purposes and it was only the tax treatment of the flows of money attributable to the refundable commission payments and commission repayments that were the subject of the appeal.

In the High Court, Dobson J upheld the Commissioner's assessments on the basis that the refundable commission payments and repayments between Sovereign and Gerling constituted a financial arrangement for the purposes of the accrual rules and were taxable in accordance with subpart EH of the Act. The deduction of the interest component was spread over the life of the arrangement. Accordingly, the refundable commission payments received by Sovereign from the German reinsurers were not accessible income and the commission repayments were not deductible expenses as returned by Sovereign in the 2000–06 income years.

On appeal, Sovereign argued that the transaction fell within section EH 10(2) of the Act so that the accrual rules did not apply (this was an argument that the base component of the transaction was attributable to a sale of property). Sovereign argued that the refundable commissions received were income earned by "sales of cash flows" from ceding the persistency risk (the risk that new life insurance contracts would be cancelled by the insured before the costs incurred in writing a new policy were recouped) to the German reinsurers. Sovereign further argued that, while there was a financing element to the treaties, they were not loans because the treaties did not provide a requirement for the commissions to be repaid. Sovereign argued there was merely an "expectation" to make the repayment of the refundable commissions. Therefore, in Sovereign's submission, the refundable commissions were not a "debt or debt instrument" for the purposes of the accrual rules (as per the definition of financial arrangement in EH 14 of the Act).

The Commissioner argued that the refundable commissions were subject to the accrual rules and that only the interest component was deductible (and spread).


Harrison J (also giving the reasons of Miller J as White J gave his own reasoning) dismissed Sovereign's appeal and upheld the Commissioner's assessment. At [48]:

  • We agree with Mr Goddard. In this Court, as in the High Court, Mr McKay accepts that the commission transactions fell within the broad definition of a financial arrangement. The financing component of the treaty was an arrangement whereby Sovereign obtained money from Gerling (the commission payments) in consideration for promising to pay money in the future (the commission repayments). This element of deferred consideration is central to the rules. So, too, is the regime's inherent dilution of the orthodox distinction between capital and revenue, ensuring a neutral tax treatment regardless of form. The focus is on the economic effect of the transaction - in this case the commissions and other repayments.

Harrison J then went on to discuss (from [61] onwards) the legal nature of the base component and the principles and case law relevant to the capital/revenue distinction. His Honour concluded that the refundable commission payments were not derived as income and that the repayment of the base component of the commission repayment was not incurred in deriving income. His Honour stated, at [125], that the legal character of the commission arrangements was that of a loan.

White J agreed with the majority's decision that the Commissioner's application of the accrual rules was correct. He stated, at [130], that in his view, it was not necessary to address Sovereign's submissions on the basis that the accrual rules did not apply.

Income Tax Act 1994