ATO ID 2004/917: Portfolio transfer of general insurance liabilities: consideration received in respect of reinsurance recoveries under cancelled reinsurance contract
Date of decision: 1 November 2004
Year of income: Year ended 30 June 2004
Business line: Public Groups and International

Issue
Is the amount of consideration received by a general insurance company from a reinsurance company in respect of reinsurance recoveries receivable under a reinsurance contract that is cancelled because of a portfolio transfer assessable under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision
Yes. The amount of consideration received by a general insurance company from a reinsurance company in respect of recoveries receivable under a reinsurance contract that is cancelled because of a portfolio transfer is assessable under section 6-5 of the ITAA 1997.

Facts
The taxpayer is a general insurance company for the purposes of section 995-1 of the ITAA 1997 and the Insurance Act 1973. The taxpayer has a reinsurance contract with a reinsurance company. The purpose of the reinsurance contract is to reduce the taxpayer's exposure to claims liability. The taxpayer, in reducing its risk exposure, paid a reinsurance premium to the reinsurance company for which it received a deduction for the whole of the expenditure incurred. The reinsurance premium is a 'relevant reinsurance premium' as defined under section 321-60 of Schedule 2J of the Income Tax Assessment Act 1936 (ITAA 1936). The taxpayer entered into a portfolio transfer arrangement with the reinsurance company. Under the terms of the arrangement the reinsurance contract is to be cancelled. The taxpayer intends to cease its insurance operation after the portfolio transfer. The reinsurance company, on cancellation of the reinsurance contract, is required to settle its obligations to the taxpayer and pay out moneys owing under the reinsurance contract. Normally these moneys, commonly referred to in the industry as reinsurance recoveries, would be received by an insurance company when it pays or settles its claims under policies of insurance.

Reasons for decision
Summary: Section 6-5 of the ITAA 1997 states that 'your income includes income according to ordinary concepts, which is called ordinary income.' The characterisation of the consideration received by the taxpayer will determine whether the amount is assessable under section 6-5 of the ITAA 1997. In Heavy Minerals Pty Ltd v. Federal Commissioner of Taxation (1966) 115 CLR 512; (1966) 14 ATD 282; (1966) 10 AITR 140, Windeyer J considered the characterisation of the compensation received arising from the cancellation of a contract. In that case, the taxpayer was a mining company that had entered into a contract to supply rutile to an overseas purchaser at an agreed price. The price of rutile fell, and the purchaser compensated the taxpayer for a cancellation of the contract. Windeyer J held that the amount received by the taxpayer was ordinary income. The characterisation of termination payments under a contract was also considered in Allied Mills Industries Pty Ltd v. Federal Commissioner of Taxation (1989) 20 FCR 288; 89 ATC 4365; (1989) 20 ATR 457. In the joint decision of Bowen CJ, Lockhart and Foster JJ it was stated that: Contracts are made to be performed, not terminated, so in one sense the termination of contracts will be outside the ordinary course of business. Yet it is clear that payments upon the termination of contracts may be of an income nature. What is important in characterising the payment is not the fact that it is made as compensation for the termination of the contract, which will often be outside the ordinary course of business, but rather the nature of the contract which generated the payment, and the way in which that contract related to the structure and business of the taxpayer. The fact that the cancellation of the reinsurance contract is a precursor to the taxpayer ceasing its insurance business does not of itself determine the character of the payment received by the taxpayer. Rather, it is the nature of the contract in the taxpayer's business that is the determinative factor. The reinsurance contract was entered into as part of the taxpayer's business operations, and reduced the taxpayer's risk to claims liability. The reinsurance contract is not considered to form part of the taxpayer's capital structure. Upon cancellation of the reinsurance contract the taxpayer received payment which in turn was used to discharge its obligations under its policies of insurance. The payments compensate the taxpayer for amounts that it is expected it would have been paid under the reinsurance contract if the contract had not been cancelled. The payments are therefore of an income nature. Accordingly, the consideration received by the taxpayer in respect of recoveries receivable under a reinsurance contract cancelled under a portfolio transfer is assessable income under section 6-5 of the ITAA 1997. | Detailed Reasoning - Application of this ATO ID from 1 July 2010: From 1 July 2010, the Tax Laws Amendment (Transfer of Provisions) Act 2010 repealed Schedule 2J of the ITAA 1936 and rewrote those provisions into Division 321 of the ITAA 1997. The wording and format was altered to adhere to the drafting approach taken in the ITAA 1997, but as outlined in Chapter 6 of the Explanatory Memorandum to the Tax Laws Amendment (Transfer of Provisions) Bill 2010, there has been no change in meaning of the rewritten provisions. Therefore, from 1 July 2010, the reference to Section 321-60 of the ITAA 1936 should be read as referring to Section 321-60 of the ITAA 1997.

Legislative references: Income Tax Assessment Act 1997 section 6-5 section 321-60 section 995-1
Case references: Heavy Minerals Pty Ltd v. Federal Commissioner of Taxation (1966) 115 CLR 512 (1966) 14 ATD 282
Related ATO interpretative decisions: ATO ID 2004/910 | ATO ID 2004/911 | ATO ID 2004/912 | ATO ID 2004/913 | ATO ID 2004/914 | ATO ID 2004/915 | ATO ID 2004/916 | ATO ID 2004/918 | ATO ID 2004/919 | ATO ID 2004/920 | ATO ID 2004/921 | ATO ID 2004/922 | ATO ID 2004/923 | ATO ID 2004/924 | ATO ID 2004/925 | ATO ID 2004/926 | ATO ID 2004/927 | ATO ID 2004/928 | ATO ID 2004/929 | ATO ID 2004/930
Other references: Explanatory Memorandum to the Tax Laws Amendment (Transfer of Provisions) Bill 2010
Subject references: General insurance General insurance industry Reinsurance & reinsurers