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Is the net profit on disposal of an asset held by a subsidiary of an insurance company included in its assessable under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No. The net profit from the disposal of the investment asset held by the subsidiary of the insurance company is not included in assessable income under section 6-5 of the ITAA 1997.

The subsidiary of a life insurance company acquired an interest in an infrastructure joint venture project (the asset). Primarily, the asset was seen as providing for an immediate income stream. The company also saw an opportunity in the longer term for a capital gain. Restrictive covenants between the joint venturers prevented the ready disposal of the asset. The acquisition was funded by contributed equity, operating revenues and interest free loans from its parent company. The balance of the loans varied throughout the years that the asset was held.

The parent company included the value of its shareholding in the subsidiary company in its solvency and capital adequacy for prudential purposes despite considering the investment illiquid as the asset could not easily be realised. The parent company had sufficient other capital in itself to meet its insurance needs.

The illiquid nature of the investment was further supported by the accounting treatment that recognised the investment as long-term.

After an extended period of participation in the joint venture the subsidiary received an offer to purchase its interest in the asset from one of the other joint venture participant. Because the terms contained in the joint venture agreement were restrictive it was unlikely that the asset could be disposed of to outside parties. Therefore, if the offer was rejected it would be some time before another opportunity for disposal would arise. Consequently it was decided that this provided a suitable opportunity to dispose of the asset.

The disposal resulted in a net gain to the subsidiary which was used in part to repay its outstanding loan and pay a dividend to the parent company.

The net profit or loss on realisation of an investment by a subsidiary of an insurance company will be on revenue account if the subsidiary's activities are integral to the parent company's insurance business ( GRE Insurance Limited v. Commissioner of Taxation (1992) 34 FCR 160; 92 ATC 4089; (1992) 23 ATR 88; Unitraders Investments Pty Limited v. FC of T 91 ATC 4454; (1991) 22 ATR 83 (GRE Unitraders)).

However, in GRE Unitraders the Full Court of the Federal Court accepted as fact, that the subsidiary had been introduced to preserve the benefits of the rebate under former section 46 of the Income Tax Assessment Act 1936 (ITAA 1936). The activities of the subsidiary were therefore integral to the business of the parent insurance company, and the profit on disposal was assessable under section 25 of the ITAA 1936 (see now section 6-5 of the ITAA 1997).

Unlike in GRE Unitraders , the taxpayer was not a special purpose company interposed for the purpose of preserving the section 46 rebate as the subsidiary did not hold any securities which yielded dividends.

Other factors that may be crucial in determining the proper characterisation of the profit or loss on disposal are whether the funds made available to the subsidiary formed part of the parent company's circulating capital (or were surplus to its needs), and whether the inclusion of the subsidiary's assets, via its shareholding value, in the parent company's statutory solvency calculation is sufficient to taint the asset as integral to the parent's company's business of insurance.

It is common ground that the funds used by the parent company to acquire the shareholding in the subsidiary were sourced from its insurance business.

The funds made available to the subsidiary via its share subscription and loans were funds that met the description of 'circulating capital' of the parent company ( RAC Insurance Pty Limited v. F C of T 90 ATC 4737; (1990) 21 ATR 709 ( RAC Insurance )) The extent to which the notion of 'circulating capital' applies to subsidiaries of insurance companies was explored by Hill J, at first instance, in AGC (Investments) Limited v. F C of T 91 ATC 4180; (1991) 21 ATR 1379.

Hill J, though finding for the Commissioner (his decision was subsequently reversed on appeal) recognised that a subsidiary is a separate legal entity and the funds it acquires from its parent company, although circulating capital of the parent insurance company, are not its own circulating capital.

Whilst the Courts have recognised that there is to be a distinction between the two entities it does not detract from the fact that the circulating capital of the subsidiary may still be available to the parent insurance company. Woodward J in the CMI Services v. F C of T 89 ATC 4847; (1989) 20 ATR 1152 (CMI Services) recognised that this could be the case. However, Woodward J also accepted that where an insurer's surplus funds are used to set up and run another business which is distinct from its insurance business the assets of that business cease to be stamped with the identity of assets available to meet insurance claims; and this is even so if the second business is an investment business.

However, that conclusion can only be reached once an enquiry is made of the relationship between the subsidiary and its parent and 'whether the assets have genuinely ceased to be part of the reserves of the insurance company' (CMI Services).

The availability of funds to the parent may be made, for example, by way of loans or by repayment of loans.

In CMI Services Woodward J examined the purpose of repayment of a loan and whether the parent insurance company became a debtor to the subsidiary. He found that the repayment lacked the connection with the payment of claims and had been made out of retained profits.

In the present case, the parent insurance company had available capital that was more than sufficient to meet policyholder liabilities as and when they arose, even in the event of a severe downturn in the market.

The loan history reveals that at all times during the joint-venture involvement the subsidiary had an outstanding balance. Whilst the quantum of the loans fluctuated the repayments reflected the ability of the subsidiary to settle its obligations to its parent insurance company. At no time during the course of the joint venture was there a role reversal so that the parent company became a net borrower and the subsidiary the lender. Thus there is no evidence of the parent company having treated the assets of the subsidiary as readily available for its business of insurance.

Woodward J in CMI Services continued, to explore the nature of the investments that had been acquired and found that because of the nature of the assets and the time needed to sell them made them impracticable to meet insurance claims.

The subsidiary's investment in the asset was limited to an interest in an infrastructure project. By its nature, the asset was not readily realisable, firstly because of the nature of the asset, and secondly because of the terms contained in the joint venture. Whilst assets that are not easily realisable were held to be assessable in Australasian Catholic Assurance Co Limited v. Federal Commissioner of Taxation (1959) 100 CLR 502; (1959) 11 ATD 577; (1959) 7 AITR 440 that case can be distinguished as the investments were directly owned by an insurance company and not via a subsidiary.

Another aspect that requires examination is the necessity that an insurance company maintain liquidity in order to conduct business. In AGC (Investments) Limited v. F C of T 92 ATC 4239; (1992) 23 ATR 287 the Full Court of the Federal Court examined liquidity and inferred that the liquidity of an insurance company could only be maintained by a regular turnover of easily realisable assets. This was also recognised in RAC Insurance when the Full Court of the Federal Court acknowledged that an asset acquired in the course of carrying on insurance business must 'be available for realisation as and when required'.

Having regard to the following factors: • the subsidiary's asset had been acquired demonstrably for the production of an income stream rather than for capital gain • there were significant restrictive covenants affecting the ready disposition of the subsidiary's asset; these supported the contention that the asset was not acquired with predominantly for the purpose of profit making by sale • the existence of the restrictive covenants prevented ready access by the parent company to the asset of the subsidiary company to support the business of insurance, and • in the event the insurance parent company required funds to meet its liabilities to policyholders, it would have relied on other realisable and more liquid assets. Although the parent insurance company's shareholding in the subsidiary (which reflected the value of the investment held by the subsidiary) may have added to its liquidity strength, there was no necessity that it be relied on to meet policyholders' liability

the asset lacked the necessary connection to the business of insurance carried on by its parent insurance company to determine that it was held as part of that business. The profit made on disposition was therefore not assessable to the subsidiary under section 6-5 of the ITAA 1997. Rather, the subsidiary made a capital gain on the disposal.