Division 15 of Part III of the Income Tax Assessment Act 1936: contract between a non-resident insurance company and a resident insurance company to make good a loss from a surety bond

Is a contract under which a non-resident insurance company agrees to participate in the risk that a resident insurance company has assumed under a surety bond an insurance contract under section 141 of the Income Tax Assessment Act 1936 (ITAA 1936)?

Yes. A contract under which a non-resident insurance company agrees to participate in the risk that a resident insurance company has assumed under a surety bond is an insurance contract under section 141 of the ITAA 1936.

ABC is an Australian insurance company that enters into contracts under which ABC undertakes to secure certain obligations owed by a principal to a creditor. The company describes the contract as a surety bond contract. If ABC is called upon under the surety bonds by the creditor to meet an obligation of a principal, ABC (as surety) has a right of recovery against the principal for amounts paid by the ABC to the creditor.

Examples of obligations covered by these surety bonds include performance obligations (for example, under a construction contract), payment obligations, maintenance obligations and payment of duties obligations.

XYZ is a reinsurance company that is not a resident company of Australia for income tax purposes.

XYZ enters into a contract with ABC under which, in return for a premium, XYZ will participate to an agreed extent in the risk that ABC has assumed under the surety bonds where ABC is unable to recover an amount from the principal.

Section 141 of the ITAA 1936 sets out that:

insurance contract means a contract or guarantee whereby liability is undertaken, contingent upon the happening of any specified event, to pay any money or make good any loss or damage, but does not include a contract of life assurance.

The section identifies four criteria that must be present in order for there to be an insurance contract: • a contract or guarantee • under which liability is undertaken • contingent upon the happening of any specified event, and • to pay any money or make good any loss or damage.

The arrangement between ABC and XYZ is a contract and therefore meets the first criterion of the definition of insurance contract in section 141 of the ITAA 1936.

The second criterion requires that a liability must arise under the insurance contract. The Macquarie Dictionary , 2005, 4th ed, The Macquarie Library Pty Ltd, NSW defines liability as 'an obligation, especially for payment'. Jowitt's Dictionary of English Law defines 'liability' as: ... the condition of being actually or potentially subject to an obligation, either generally, as including every kind of obligation, or, in a more special sense, to denote inchoate, future, unascertained or imperfect obligations, as opposed to debts, the essence of which is that they are ascertained and certain. Thus, when a person becomes surety for another, he makes himself liable, though it is unascertained in what obligation or debt the liability may ultimately result.

Under the surety bond ABC has taken on the liability that it will meet the demands of creditors in the event of default by debtors. Under the contract between XYZ and ABC, XYZ has accepted to take on a liability in return for a premium. Accordingly, the second criterion of the definition of insurance contract in section 141 of the ITAA 1936 is satisfied as a liability arises for XYZ under the contract between XYZ and ABC.

The next criterion is that the liability that arises for XYZ must be contingent upon the happening of a specified event. Under a surety the 'liability of a surety to the third party is contingent upon the debtor failing to meet his or her obligation': Coles Myer Finance Ltd v. Federal Commissioner of Taxation (1993) 176 CLR 640; 93 ATC 4214; (1993) 25 ATR 95 per McHugh J at CLR 685; ATC 4232; ATR 120. In this respect, the demand by the creditor on ABC will in turn result in a demand being made by ABC on XYZ if ABC is unable to recover an amount from the principal. Accordingly, the liability of XYZ is contingent upon the happening of this specified event and the third criterion of the definition of insurance contract in section 141 of the ITAA 1936 is satisfied.

The last criterion is that the liability must be for the payment of money or the making good of any loss or damage. XYZ is required to pay amounts to ABC in accordance with the terms of the respective contracts in relation to a loss sustained by ABC where ABC is unable to recover the loss from the principal. XYZ therefore has a liability to pay money or make good a loss on the happening of the specified events and the fourth criterion of the definition of insurance contract in section 141 of the ITAA 1936 is satisfied.

Accordingly, the contracts between XYZ and ABC are considered to meet the definition of an insurance contract in section 141 of the ITAA 1936.

The inclusion of suretyship, provided by insurance companies, within the statutory definition of insurance contract is supported by the intent of Division 15 of Part III of the ITAA 1936 which can be ascertained from an examination of the equivalent provision in the Income Tax Assessment Act 1922 (ITAA 1922) which preceded the introduction of the ITAA 1936.

The prevailing provision that governed the insurance premiums paid to a non-resident insurance company was subsection 28B(1) of the ITAA 1922. Clause 14 of the Explanatory Memorandum to the Income Tax Assessment Bill 1930 (which inserted section 28B into the ITAA 1922) stated that the provision was being inserted to: ... cause income tax to be payable by or on behalf of ex-Australian underwriters such as Lloyd's Insurance Association of London upon an assumed profit of 10 per cent. of all premiums on insurances effected in Australia by or on behalf of that underwriter.

The Explanatory Memorandum makes clear that it was the intention that all forms of insurance business provided by non-resident insurers, such as Lloyd's Insurance Association of London (Lloyd's), would be the subject of section 28B of the ITAA 1922. Insurance business undertaken by Lloyd's at this time extended to suretyship. This is demonstrated by the case Trade Indemnity Co Ltd v. Workington Harbour and Dock Board [1936] 1 All ER 454 where Lord Atkin, in summarising the case before him, referred at All ER 458 to the fact that Trade Indemnity had 'reinsured' its risks under surety bonds with 'other persons carrying on business in the insurance world, notably at Lloyd's'.

Accordingly, treating the contract entered into by XYZ with ABC as an insurance contract as defined in section 141 of the ITAA 1936 is considered to be in accordance with the intent of Division 15 of Part III of the ITAA 1936.