The Judicial Committee of the Privy Council Decisions

Inland Revenue v. Colonial Mutual Life Assurance Society Ltd (New Zealand) [2001] UKPC 54 (4 December 2001)

Privy Council Appeal No. 64 of 2000

The Commissioner of Inland Revenue Appellant v.

Colonial Mutual Life Assurance Society Ltd. Respondent

FROM

THE COURT OF APPEAL OF NEW ZEALAND

JUDGMENT OF THE LORDS OF THE JUDICIAL

COMMITTEE OF THE PRIVY COUNCIL,

Delivered the 4th December 2001

------------------

Present at the hearing:-

Lord Nicholls of Birkenhead

Lord Browne-Wilkinson

Lord Steyn

Lord Hoffmann

Sir Kenneth Keith

[Delivered by Lord Nicholls of Birkenhead]

------------------

1. This appeal raises a point of interpretation of the legislation which governed the taxation of life insurance companies for the years 1983 to 1990. The legislation is no longer in force. The issue concerns interest charged to policyholders in respect of late payment of premiums on traditional whole of life or endowment policies. The question is whether, on the proper interpretation of section 204 of the Income Tax Act 1976, this interest is deemed to be part of the profits derived from the company's life insurance business and taxable accordingly. The issue has attracted some difference of judicial opinion.
2. The taxpayer company is Colonial Mutual Life Assurance Society Ltd, or CML for short. CML charges its policyholders interest on overdue insurance premiums. This appeal relates to amended income tax notices of assessment issued in 1998. By these notices the Commissioner of Inland Revenue treated such interest as assessable income of CML. The relevant assessments relate to the income years 1987 to 1990. The amount involved is NZ$3,600,924.
3. Hammond J dismissed CML's appeal against the disputed assessments. He regarded himself as bound by a decision of the Court of Appeal, given as long ago as 1902, in Commissioner of Taxes v The Australian Mutual Provident Society (1902) 22 NZLR 445. This was a majority decision, the majority comprising Williams, Conolly and Edwards JJ. Stout CJ dissented. Hammond J said that, had he not been precluded from so deciding, he would have had little difficulty in aligning himself with the dissenting judgment of Stout CJ. Hammond J has not been alone in preferring the opinion of Stout CJ. Two Australian courts have expressed a similar preference: see Australian Mutual Provident Society v Commissioner of Taxes (1907) SALR 88 and The Crown v National Mutual Life Association of Australasia Ltd (1922) 25 WALR 1.
4. CML appealed from Hammond J's decision. The Court of Appeal allowed the appeal. Once again, this was a majority decision. The majority comprised Richardson P, Henry J and Blanchard J. Gault J and Thomas J disagreed. The Commissioner of Inland Revenue has now appealed to their Lordships' Board.

The insurance policy

5. What is in issue is the fiscal consequence of the transaction embodied in the relevant classes of CML insurance policies. Thus the starting point must be the terms of the policies. Typically, a relevant CML insurance policy provided that subject to payment of the stipulated premiums or instalments, and to the terms and conditions of the policy, CML would pay the policy benefits to the insured. The policy benefits were a sum of money, with or without bonuses, payable variously either on the death of the insured or on his survival to a stated age or earlier death. The policy acquired a surrender value after it had been in force for two years and two years' premiums had been paid.
6. Condition 2(i), concerning payment of premiums, provided that premiums must be paid within one calendar month of the due date. Under paragraph (a) the policy would be forfeited if default were made in payment of any premiums before the policy had been in force for two years and two years' premiums had been paid. Paragraph (b) provided what should happen if default were to occur at a later stage, that is, after the policy had been in force for two years and two years' premiums had been paid and the policy had thus acquired a surrender value (for convenience the sentences in this paragraph have been numbered):

"[1] If default be made in the payment of any premium after this policy shall have been in force for two years and two years' premiums shall have been paid, the policy shall not become void until its surrender value after deduction of any debt shall become insufficient to pay one quarterly premium … or if the premium be payable more frequently than quarterly, shall become insufficient to pay one premium. [2] If a claim arise during the continuance of such default and before forfeiture through the exhaustion of the surrender value, the amount hereby insured will be payable subject to the deduction of any debt. [3] The debt on any policy is defined as arrears of premium plus compound interest and any policy loan plus compound interest."

7. Thus, once the policy has acquired a surrender value, default does not result automatically in forfeiture of the policy. The policy remains in being, until the amount of the arrears plus compound interest reaches a level where the surrender value, after deducting the arrears and interest, is less than the amount of, stated loosely, the next premium.
8. Although the first sentence of condition 2(i)(b) speaks of the surrender value being insufficient "to pay" one quarterly premium, it is clear from the condition as a whole that this provision does not mean that, in law, the arrears are paid off as they arise by recourse to the policy's surrender value. This is apparent from the reference to arrears of premium in the third sentence and the description of these arrears, together with interest, as "the debt". If the policy matures whilst default is continuing, the policy benefits are reduced by the amount of the debt, namely, the premium arrears together with compound interest thereon. Until then, in law, the overdue premiums remain outstanding and unpaid. If the policy lapses as envisaged in the first sentence of condition 2(i)(b), the policyholder loses the benefit of the surrender value. It is implicit in this provision that, at that stage, the surrender value is set off against the debt as defined.
9. The Commissioner sought to establish the contrary. He submitted that when a policyholder fell into arrears with payment of premiums CML thereupon advanced the amount of the arrears to the policyholder by means of book entries. There was a notional loan made automatically by CML to the policyholder. Again by means of book entries, CML then charged compound interest on this notional advance, at the same rates as those charged to policyholders who had actually been loaned money on the security of their policies.
10. This submission is untenable. CML's method of bookkeeping could not of itself change the nature of the parties' contractual relationship. Moreover, the position regarding CML's accounting records appears to be that the method of bookkeeping relied upon by the Commissioner was adopted by CML to conform with its statutory reporting obligations under the (Australian) Life Insurance Act 1945. The evidence does not establish that CML purported to treat the arrears as extinguished and replaced by a loan of equivalent amount from CML to the defaulting policyholder.
11. For completeness, passing mention should be made of the Life Insurance Act 1908. The provisions in condition 2 of CML's policies are consistent with the overriding statutory requirement of section 64 of the Life Insurance Act 1908 that a policy shall not become void by non-payment of premiums so long as the premiums and interest in arrears do not exceed the policy's surrender value. Nothing turns on this for the purposes of the appeal. In the case of the CML policies under consideration, it is the terms of the policies themselves, not the provisions of the statute, which keep alive the policies despite non-payment of premiums on due date. Nor need reference be made to the enabling power in section 63 of that Act, which empowers a company to "apply" the surrender value of a policy to keep the policy in force. The relevant power in the present case is the express power contained in the policy's own conditions.

The legislation

12. Section 204 of the Income Tax Act 1976, in the form material on this appeal, was introduced into that Act by section 34 of the Income Tax Amendment Act (No 2) 1982. The background to this change in the taxation of life insurance companies is set out in the judgment of Richardson P in the Court of Appeal, in paragraphs 2 to 9. Section 204 is long and intricate. The section applies to every company engaged in the business of life insurance where the Commissioner is satisfied that the business consists of two matters. The first is the issue by the company of policies of life insurance or the entering into of contracts of reinsurance in relation to policies of life insurance or the granting of annuities. The second is 'the investment and management of money received by way of premiums in respect of those policies and consideration for those contracts and annuities': see section 204(2).
13. Section 204(9) is the charging provision. Subject to adjustments, every company to which the section applies is deemed to have derived income from its life insurance business, and be liable to income tax accordingly, in an amount equal to its profits ascertained in accordance with subsection (8). To understand section 204(8) it is necessary first to note the elaborate definition or description of gross revenue in section 204(1):

"'Gross revenue', in relation to any company to which this section applies ... means the gross revenue derived by that company in carrying on its business of life insurance and reinsurance and granting of annuities; and includes-

(a) Premiums on policies of life insurance issued by that company, reduced by the amount of any premiums or other considerations paid or payable in respect of contracts of reinsurance made in respect of those policies:

(b) Premiums or other considerations received or receivable by that company in respect of contracts of reinsurance made in respect of policies of life insurance issued by any other person:

(c) Considerations received or receivable by that company in respect of the granting of annuities:

(d) Total revenue received or receivable by that company from its investments otherwise than by way of sale or other disposal of any investment:

(e) The aggregate amount of all profits derived from the sale or other disposal of any investment of that company:

(f) All commissions and fees received or receivable by that company ...

reduced by the aggregate amount of all losses incurred in carrying on its business of life insurance on the sale or other disposal of any investments of that company:"

14. Section 204(8) provides that, for the purpose of assessing income tax, every company is deemed to have derived profits from its business of life insurance in an amount equal to its "gross revenue" for the relevant income year, reduced by the total of three items. The first of these items is the aggregate of all the premiums and other considerations mentioned in paragraphs (a), (b) and (c) of the definition of gross revenue in subsection (1) received or receivable by the company in that income year. The second and third items are the amount of the "direct investment revenue costs" and the amount of the "indirect investment revenue costs" incurred by the company in that income year.
15. It is now possible to identify the point of statutory interpretation which divides the parties. It is common ground, and rightly so, that the interest charged on overdue premiums is part of CML's gross revenue. CML's case is that this interest falls within paragraph (a). It is a premium on a policy of life insurance within the meaning of that expression in section 204. Hence, in accordance with section 204(8), such interest is deductible when calculating the amount of CML's life insurance profits. The Commissioner disputes this interpretation of the legislation. As presented to their Lordships' Board, the Commissioner's primary case is that interest charged on overdue premiums is within paragraph (d), as revenue received from CML's investments. Hence it is not deductible.

The interpretation of section 204

16. The most obvious and notable feature of section 204 is that the section divides a life insurance company's flow of revenue into two distinct streams, depending upon the source from which the revenue comes. One stream comprises revenue whose source is the investments of the company. This is the investment revenue stream. It is taxable. The other stream comprises revenue whose source is premiums and other consideration payable to the company in respect of policies of insurance, reinsurance and annuities. This is the premium revenue stream. It not taxable. More precisely, the (taxable) investment revenue stream comprises all the gross revenue less the premium revenue stream and less also the direct and indirect investment revenue costs, reduced by the total of all losses incurred on the sale of investments. Indirect costs include matters such as head office administration expenses. These are apportioned between the two revenue streams in accordance with a formula set out in the section.
17. This division of the company's gross revenue into two streams, and the reason for it, are crucial to an understanding of the section and its proper interpretation. The expressions "premium" and "investment" are flexible terms. Each of them is capable of bearing the meanings for which the parties contend. Thus, in ordinary usage interest on overdue premiums is often so described rather than as a further premium. This usage is reflected in condition 2 of the typical CML policy. The third sentence of condition 2(i)(b) defines the debt as arrears of premium plus compound interest. Premiums and interest are treated as two different species. In at least one regard they are different. Unlike premiums, interest on overdue premiums contains no element in respect of the cost of the mortality risk covered by the policy. As already noted, CML simply charges interest on overdue premiums at the same rate as it charges interest on loans made to policyholders on the security of their policies. But, without any distortion of language, "premium" may also be used in a wider sense which embraces all consideration payable by the policyholder in accordance with the terms of the policy in order to obtain the policy benefits. On this approach interest on an overdue premium is an adjustment made to the amount of the premium when it is paid late.
18. Likewise with the expression "investment". Unpaid instalments of a purchase price would not normally be described as an investment, even if they carry interest. Arrears of premium are comparable. The life office has received nothing. It has not laid out anything from its resources, such as making a loan to the policyholder. It is merely awaiting payment of an agreed premium. But, nevertheless, in an extended sense of the word "investment", arrears of premium may be regarded as a form of investment and the accruing compound interest as revenue derived therefrom. Overdue premiums and interest are, in effect, a charge on the policy's surrender value. In due course, by one means or another, the life office will recoup these arrears with interest. It will do so, either by the defaulting policyholder paying off his arrears and interest, or by these outstanding sums being deducted from the policy benefits on maturity of the policy, or by these sums being set off against the policy's surrender value when the policy lapses.
19. So what are the meanings with which investment and premium are used in section 204? The narrower meaning of premium and the wider meaning of investment? Or the wider meaning of premium and the narrower meaning of investment? As the history of this case shows, these are questions on which different judicial minds may reach different conclusions.
20. Having had the advantage of the full exploration of the issues in the judgments of Hammond J and the Court of Appeal as well as the submissions of counsel, their Lordships consider that the latter interpretation, propounded by CML, is preferable. This interpretation gives better effect to the statutory purpose, by according more satisfactorily with the underlying rationale of the section. This rationale was summarised in the Treasury's Consultative Document on Superannuation and Life Insurance, issued in March 1988, vol 1, pages 54-55. New Zealand's income tax system, as set out in section 204, adopted the approach of considering life offices as a conduit through which income passes to policyholders. Rather than attempting to tax the policyholder on his share of the income of the life office, tax is levied on the conduit (the life office). The life office is taxed as a proxy for the policyholder and is not taxed in its own right. The policyholder "income" which section 204 tries to tax is the income generated by accumulated premiums.
21. In accordance with this rationale there is no good reason for treating payment of interest on overdue premiums differently from payment of the overdue premiums themselves. Neither is income generated by accumulated premiums. Rather, both are part of the consideration payable by the policyholder to the company, pursuant to the terms of his policy, in return for the promised benefits. Arrears of premiums will be paid to the company either by the policyholder or at his expense. Failing actual payment by the policyholder, the company will recoup these arrears by recourse to the policy benefits or the policy's surrender value. Interest on arrears will be paid to the company by the policyholder or at his expense in a similar fashion. Arrears of premium, receivable in one or other of these ways, are admittedly part of the premium stream of revenue. Payment of interest coming from one or other of the same sources and being made in respect of the same consideration, the same classification must be equally applicable. As between the two revenue streams identified by section 204, overdue premiums and interest both form part of the same stream.
22. This result is readily achieved by ascribing to the expression "premiums" in section 204 the wider meaning already mentioned. In section 204 premiums is used in that wider sense. Premiums are the price payable by policyholders for the agreed benefits. The phrase 'revenue received or receivable by the company from its investments' in paragraph (d) is directed at receipts derived by the company from the use it makes, by way of investment, of money received from policyholders pursuant to the terms of their policies.
23. Their Lordships recognise that this interpretation places interest receivable by the company on a loan made on the security of a policy and interest accruing on overdue premiums into different streams of income for tax purposes. It does so even though, as far as a policyholder is concerned, there is little practical difference between the two if the loan is used by the policyholder in paying his premiums. But there is a material distinction between arrears of premium and a loan. In the ordinary way a loan is not one of the policy benefits. Interest payable on a loan is not part of the consideration payable by the policyholder, or receivable by the company, in respect of the policy. The consideration for the policyholder's obligation to pay interest lies elsewhere. It is not surprising, therefore, that interest on a loan forms part of the company's investment stream of revenue for tax purposes. It is payable in respect of a loan which the company has agreed to make from its resources. The use of this loan by the policyholder in paying his policy premiums does not affect the character of the transaction.
24. The Commissioner also placed some reliance on the fact that the purpose for which interest is charged on an overdue premium is to make good the loss of income sustained by the life office by reason of not receiving prompt payment. Had the premium been paid timeously, and duly invested, the life office's income from its investment would have been taxable in the hands of the life office. The income would have fallen within paragraph (d), and it would not have been deductible pursuant to section 204(8). It would be anomalous, it is said, if receipt by the life office of an equivalent amount from the policyholder, calculated as interest, were treated differently for income tax purposes.
25. This argument is not persuasive. The place at which the dividing line is drawn is bound to give rise to seeming incongruities when some transactions are considered in terms of economic equivalence. For instance, premiums payable, say, by quarterly or monthly instalments are charged at a higher rate than premiums paid annually. The major part of the increase is to compensate the company for the loss of interest which, had the premium been paid annually, would have been received by the company. This interest would have been taxable in the company's hands. But no one has suggested that part of the premiums paid quarterly or monthly should be treated as revenue received from an investment.
26. The reason for these apparent anomalies is that all premiums on whole of life or endowment policies contain a large element in respect of the so-called time value of money. Whenever the date on which a premium is paid or payable is changed, the interest element in the amount of the premium calls for corresponding adjustment, either upwards or downwards. When such an adjustment is made the company is entitled to deduct from its gross revenue the amount of the adjusted premium, be it more or less than the unadjusted premium. If the premium is reduced, the company is entitled to deduct only the reduced amount. If the premium is increased the company may deduct the increased amount. This is so, even though the purpose of the upward or downward adjustment of the premium was to compensate for a corresponding decrease or increase in its stream of investment income.
27. Thus, if a policyholder were to arrange to pay his premiums earlier than originally agreed, and the amount of the premiums were reduced accordingly, the company would have to pay tax on the additional investment revenue generated in consequence of the premiums being received by the company sooner rather than later. The company would have to pay tax on this additional investment revenue although, had the corresponding revenue been received in the form of premium as originally arranged, it would have been deductible for tax purposes. The payment of interest on arrears of premiums is no more than a stark example of the converse case, where a premium is paid late and is adjusted upwards.
28. The Commissioner had a second string to his bow. His suggested alternative was that interest on overdue premiums is neither a premium within paragraph (a) nor revenue receivable by the company from its investments within paragraph (d). Accordingly it is taxable, because it forms part of gross revenue but is not deductible as falling within paragraphs (a) to (c).
29. This alternative submission presupposes that the types of gross revenue listed in paragraphs (a) to (f) are not exhaustive. The revenue received by a company in carrying on its life business may include a type or types which are not itemised in those paragraphs. Their Lordships doubt this interpretation of the definition of gross revenue. The itemised paragraphs (a) to (f) are introduced by the word 'includes'. This style of introduction suggests that the itemised types of revenue which follow are not intended to be an exhaustive description of a company's gross revenue. Despite this, the existence of residual types of gross revenue, not within any of the paragraphs (a) to (f), does not accord easily with the overall scheme of the section. In particular, on the face of the statutory language the costs incurred by the company exclusively in acquiring such residual types of taxable gross revenue would not be fully deductible, because such costs would appear to fall outside the definition of "direct investment revenue costs". Their Lordships incline to the view that read in context "includes" is used in the sense of "comprises".
30. It is not necessary, however, to express a firm view on this point. Even if the heads of gross revenue listed in paragraphs (a) to (f) are not exhaustive, interest charged on overdue premiums fits more readily into paragraph (a) than into the suggested residual category. If such interest were placed in the suggested residual category the result would be that the interest would be placed in a different stream from arrears of premium. For reasons already given, this is not an acceptable interpretation and application of section 204.
31. The Commissioner also sought assistance from the fact that, apart from section 204, interest payable on overdue premiums would be taxable. Section 65(2)(j) of the 1976 Act states that, save as expressly provided to the contrary, the assessable income of any person is deemed to include all interest. Interest is defined as including every payment made in respect of money lent. "Money lent" includes any amount of credit given or the forbearance of any debt: section 2. These provisions are nothing to the point now under consideration. Section 204 sets up a scheme of its own for life insurance companies, with its own special provisions. The proper interpretation of these special provisions gains little assistance, if any, from the treatment which would otherwise be accorded to interest chargeable on overdue premiums.
32. As to Commissioner of Taxes v The Australian Mutual Provident Society (1902) 22 NZLR 445, their Lordships need not express any view on the correctness of the actual decision in that case in so far as it was based on the interpretation of the particular wording of the relevant by-law, by-law VIII. The majority of the Court of Appeal appear to have construed the wording of by-law VIII, which differed from the wording of CML's condition 2, as giving rise to an advance of money, bearing interest, upon the security of the policy: see, for instance, Edwards J, at pp 457-458. The statutory provisions under consideration were also somewhat different from section 204. But in so far as the reasoning of the majority of the members of the Court of Appeal may be regarded as inconsistent with the views set out above on section 204, the Board is respectfully constrained to differ from that reasoning.
33. Their Lordships will humbly advise Her Majesty that this appeal should be dismissed. The Commissioner must pay CML's costs before their Lordships' Board.