ATO ID 2008/125: Application of section 121 of the Income Tax Assessment Act 1936 to a company formed for purpose of providing a financial assurance to a government authority
Date of decision: 19 September 2008
Year of income: Year ended 30 June 2007
Business line: Public Groups and International

Issue
Is a company that was formed for the purpose of providing a financial assurance to a government authority in order to satisfy conditions attached to a licence essential to another company's business an 'association of persons formed for the purpose of insuring those persons' for the purposes of subsection 121(1) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Decision
No. A company that was formed for the purpose of providing a financial assurance to a government authority in order to satisfy conditions attached to a licence essential to another company's business is not an 'association of persons formed for the purpose of insuring those persons' for the purposes of subsection 121(1) of the ITAA 1936.

Facts
A company (ABC) conducts a business on a purpose designed site. An integral part of ABC's business is the maintenance of a licence from a government authority to carry on that business. In order for ABC to maintain the licence, ABC must provide the government authority with a financial assurance in respect of the licence. The financial assurance is intended to provide a guarantee that, amongst other things, certain remedial costs in respect of ABC's business are not borne by the community. The financial assurance can be satisfied by ABC subscribing capital to a fund in conjunction with other companies that are also required to provide a financial assurance to the government authority. ABC and other companies required to provide a financial assurance to the government authority incorporated and subscribed funds into a new company (DEF) in order to provide the financial assurance. This capital subscription took the form of ABC and the other companies subscribing for shares in DEF upon its establishment and also on a quarterly basis until the fund reached the maximum amount required by the government authority. The amount of capital that must be subscribed by ABC is determined by reference to the output produced by ABC's business and the expected remediation costs in relation to the business of ABC. ABC is expected to fund any remedial action from its own resources and not from the financial assurance fund. That is, DEF will not use the money in the fund to carry out remedial action on behalf of ABC unless ABC fails to carry out that action itself. In these circumstances, DEF can either undertake the remedial work itself or arrange for the remedial work to be done. The government authority is also able to claim against DEF for reimbursement if the government authority is required to undertake remedial action.

Reasons for decision
Summary: Section 121 of the ITAA 1936 provides that a mutual insurance association is taken to be a company carrying on the business of insurance if it is 'an association of persons formed for the purpose of insuring those persons against loss, damage or risk of any kind'. The expression 'formed for the purpose of insuring those persons' refers to both the purpose for which the taxpayer was established and the activities of the taxpayer ( Cronulla Sutherland Leagues Club Ltd v. Federal Commissioner of Taxation (1990) 23 FCR 82; 90 ATC 4215; (1990) 21 ATR 300). The ITAA 1936 does not define the term 'insuring those persons'. In Taxation Ruling IT 2663 insurance is described as a contract under which an insurer undertakes a liability, contingent on the happening of any specified event, to indemnify an insured for an agreed money value of any loss or damage. 'An association of persons formed for the purpose of insuring those persons' under section 121 of the ITAA 1936 should therefore be read as a reference to an association that undertakes insurance liabilities. In Medical Defence Union Ltd v. Department of Trade [1979] 2 All ER 421, Megarry V-C cited with approval the judgement of Channell J in Prudential Insurance Company v. Commissioners of Inland Revenue [1904] 2 KB 658 ( Prudential ). Megarry J. stated that in order for an association to undertake insurance liabilities it is important to establish that in return for consideration, a benefit is secured upon the happening of a certain event. In considering whether in return for consideration a benefit has been secured upon the happening of a certain event, Channell J makes it clear in Prudential that it is important to look at the contract as a whole to determine whether there is a contract of insurance. In the present case the consideration provided is in the form of ABC subscribing for shares upon the establishment of DEF, and then on a quarterly basis until the financial assurance fund reaches its required funding level. The question is therefore whether ABC, in return for its contributions to the financial assurance fund, is secured against pecuniary loss if it is called upon to undertake remedial action in relation to its business activity. As ABC is required to pay for any remedial action from its own financial resources and not from the financial assurance fund, it is considered that ABC is not secured against pecuniary loss if remedial action is required. The financial assurance fund will only be drawn upon if ABC fails to carry out that action itself. In this case, either DEF will undertake the remedial work itself (or arrange for the remedial work to be done) or DEF will reimburse the government authority if the government authority is required to undertake remedial action. Therefore, it could be said that the risk still remains with ABC. The main purpose of establishing the financial assurance fund is to allow ABC to meet the requirements of the government authority and to maintain the licence to carry out its business operations. It is not the intention of ABC to insure its own risks and ABC will not receive any benefit from DEF if ABC is required to undertake remedial action. Rather, it is the government authority that will receive the benefit from the financial assurance fund upon the happening of the event of remedial action not being undertaken by ABC. Accordingly, DEF is not an association of persons formed for the purpose of insuring those persons against loss, damage or risk of any kind for the purposes of subsection 121(1) of the ITAA 1936.

Legislative references: Income Tax Assessment Act 1936 section 121 subsection 121(1)
Case references: Cronulla Sutherland Leagues Club Limited v. Federal Commissioner of Taxation (1990) 23 FCR 82 (1990) 21 ATR 300 90 ATC 4215
Related public rulings and determinations: Taxation Ruling IT 2663
Subject references: General insurance Insurance income Mutual insurance associations