― 339 ―

26. Chapter 20 Income Taxation in Relation to Particular Industries: General Insurance, Exempt Organisations and Mutual Associations

20.1. In Section I of this chapter aspects of the income taxation of general insurance companies are examined. In Section II the Committee considers exemptions granted to a number of organisations by section 23 of the Income Tax Assessment Act, and also the basis of assessment of co-operative companies and friendly society dispensaries. The exemption from income tax of charitable institutions is discussed in detail in Chapter 25, together with other taxation aspects relating to these institutions.

I. General Insurance

20.2. This first section deals with the operations of fire, general and marine insurance companies, which are concerned with the insurance of losses other than those covered by life insurance and those personal accident losses covered by insurance policies written by the life insurance offices. The basis of the insurance contract is that, in consideration of a payment or premium by the insured, the insurer will, on a certain event happening during a given time, pay to the insured, or some nominated person, either an agreed sum or the amount of the loss caused by the event. Fire, general and marine insurance companies insure various kinds of risks, such as loss at sea, loss by fire or accident, by burglary or breakage, by default of staff, and loss of profits consequent upon another loss.

20.3. Division 15 of the Act contains particular provisions covering insurance with non-residents. But apart from these provisions, the Act is silent on the treatment of the income of general insurance companies. Because of the nature of their business, however, the taxable income of such companies has in certain respects come to be calculated differently from the taxable income of other companies. Four special features of the industry are dealt with in turn: deferment of unearned premiums; claims incurred but not reported; catastrophe fund; and insurance with non-residents.

Determination of Earned Premiums

20.4. Throughout the tax year an insurance company receives premiums, a proportion of which will cover risks for a period after the end of that year. For this reason it has been the custom of the Commissioner to agree to the accounting practice of insurance companies to exclude from their assessable income for a year an amount equal to a proportion of the premium income for that year and to bring that amount to account in the following year.

20.5. Until 1965, the proportion of premiums received in a year that could be deferred to the next year was set at 40 per cent and representations to the Commissioner that the percentage be increased met with no success. The 40 per cent rule rests on the principle, dating back to a Court decision in the United Kingdom as long ago as 1912, that 50 per cent of premiums received as twelve-monthly business is unearned at the end of the year; and as 20 per cent is customarily allowed for costs of acquisition and documentation, the deferred amount should be 50 per cent of 80 per cent, which is 40 per cent.

  ― 340 ―

20.6. The 40 per cent rule has been criticised as it is unreal to assume that premium income and risks are necessarily distributed evenly over the year. For example, a substantial proportion of a company's contracts may be for periods of more or less than one year; or the company may receive during one year a substantial total of premiums on a new type of policy which it first commenced to write midway through that year; or part of the premiums received may refer to risks which did not commence during the year of income; or a sizeable proportion of premiums may be received in one calendar month.

20.7. The 1965 decision in the Arthur Murray Case note lent support to the Commissioner's practice of excluding unearned premiums from assessable income and led the Commissioner to amend his view as to a reasonable deferment of premiums in special circumstances. The Commissioner now began allowing individual companies to defer amounts in excess of 40 per cent of premiums received if, upon a careful examination of all the circumstances, a larger percentage was thought to be justified. Since 1968, the rules for deferment of premiums have been widened to allow for calculations by the ‘24ths rule’. Behind the latter is the assumption that a premium in connection with an annual risk is deemed to have been received in the middle of the month, and that a risk attaching to a premium received in the first month of the income year falls due as to 23/24ths in the current year and as to 1/24th in the next year. The proportions for a premium received in the second month are 21/24ths and 3/24ths respectively; and so on. The calculation is based on net premiums (that is, gross premiums less returned premiums, reinsurances, commissions and a proportion of administration expenses).

20.8. The Committee is satisfied that submissions to it calling for methods of assessing an allowance for the deferment of unearned premiums more accurate than the 40 per cent rule are met to an extent by the present acceptance of the 24ths rule. It therefore recommends that the 24ths rule be continued. However, this latter rule has its shortcomings: being based on the time at which premium is charged rather than the period of risk, it cannot be wholly accurate in all cases. Hence, as more exact methods of calculating the unearned premium are developed, they should be accepted by the Commissioner. In recommending continuance of the exclusion of unearned premiums from assessable income, the Committee is not seeking to treat the income of a general insurance company in a specially favourable way. It is concerned only with establishing a fair basis for calculating taxable income.

Claims Incurred but not Reported

20.9. Insurance companies are liable to meet claims arising from losses of the insured during the income year but not notified during that year. At the end of each year companies estimate claims which occurred during the year but likely to be made after the end of the year. Understandably, the delay in notifying claims varies according to the class of insurance business. With workers’ compensation and third-party insurance business, for instance, there may be a considerable time-lag between the occurrence of the injury, the manifestation of the symptom and of the extent of the injury suffered, and settlement of the claim. It is thus extremely difficult to calculate this provision accurately. The insurance industry as well as the Insurance Commissioner have been concerned with developing statistical techniques to enable the calculation of claims incurred but not reported to be made with greater precision.

20.10. Claims incurred but not reported have not until recently been submitted as deductions for income tax purposes. However, R.A.C.V. Insurance Pty. Ltd., in its return for the year ended 28 February 1971, sought a deduction in respect of claims reported after 1 March 1971 for accidents that had occurred during the financial year. In the assessment, the amount claimed was disallowed and the matter eventually became the subject of an appeal to the Supreme Court of Victoria.note A decision in favour of the company was given by Menhennitt, J. in June 1974 and by consent an appeal by the Commissioner was dismissed. While by the facts of the case the decision is limited to motor-car insurance and third-party insurance, the Commissioner has accepted the decision as applying to all general insurance companies. The decision is not expected to give rise to practical difficulties for the Commissioner and will undoubtedly be welcomed by the insurance industry.

  ― 341 ―

Catastrophe Fund

20.11 It has been put to the Committee in submissions that insurance companies should be allowed to deduct from taxable income additions to provisions built up to meet an exceptional aggregation of claims arising from a catastrophe. The maintenance of a high solvency margin, it is argued, would be facilitated by such deductions and the provisions would be available for emergency purposes, payments from the provisions not of course being allowable deductions.

20.12. While substantial provisions to meet unusual claims are desirable in any business, the Committee does not favour special treatment in this regard for insurance companies. The uncertainty of the basis of such provisions would cause serious administrative difficulties in deciding to what extent the amounts claimed should be allowed as deductions.

Reinsurance with Non-residents

20.13. It is not uncommon for resident insurance companies to reinsure certain risks with non-resident companies, and section 148 of the Act contains special provisions for taxing such non-residents. Amendments to the section have been sought in submissions to the Committee.

20.14. To bring the income of a non-resident reinsurer to tax in respect of premiums pertaining to insurance of property situated in Australia or of events that can happen only in Australia is an extremely complicated matter. Before 1938 the Australian insurer was assessable to tax as agent for each ex-Australian reinsurer on the profit derived by the reinsurer. The profit so derived was deemed to be 20 per cent of the premiums received by the reinsurer, unless the actual profit or loss made by the reinsurer could be established to the satisfaction of the Commissioner.

20.15. Under pressure from the insurance industry, this basis was abandoned in 1938. Thereafter, premiums paid to non-resident reinsurers and recoveries from the latter were excluded from the assessments of local insurers and the full profit or loss arising from the risk insured was included in the assessment of the local insurer.

20.16. It was found that in most cases the insurer was able to recoup from the non-resident reinsurer the tax attributable to the reinsurance in question; but some local companies were at a disadvantage when they could not make satisfactory arrangements to recoup.

20.17. To meet the disadvantages facing local companies, the Act was amended in 1947 to allow the Australian insurer either to bring to account in his own return the profit or loss derived by the reinsurer or else to return 10 per cent of the premium paid to the reinsurer as taxable income and pay tax on that amount as agent for the reinsurer.

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20.18. Representations to have the figure of 10 per cent reduced have not been successful, the Commissioner being satisfied that, over a period, 10 per cent is not excessive. A submission to the Committee that overseas reinsurers be allowed to submit income tax returns for reinsurances ceded by Australian companies would lead to the unsatisfactory complications previously outlined, and to double taxation unless the Australian insurer elected not to bear the tax on the reinsurer's profits or losses.

20.19. Section 148 (3) of the Act refers to ‘ten per centum of the sum of the gross amounts of the premiums paid or credited by him … to non-residents’. The Committee understands that the Commissioner is interpreting this as not precluding the deduction from gross premiums of returned premiums and rebates for the purposes of calculating deemed profits on premiums. This interpretation will go some way to reduce deemed profit of local insurers on reinsurance business, and the Commissioner ought to notify the insurance industry of his current interpretation.

II. Exempt Organisations and Mutual Associations

Local Governing Bodies, Public Authorities and Institutions of a Charitable Kind

20.20. The incomes of local governing bodies, including those administering public utilities, have been exempt since the inception of Federal income tax, presumably because they are statutory bodies carrying out what are thought to be functions of government. On the other hand, the main commercial and trading undertakings coming within the control of the Australian Government are subject to income tax on the same basis as a public company. Thus, for instance, the Commonwealth Trading Bank and the Australian National Airlines Commission are taxed on this basis. The Committee sees no reason to vary the existing income tax position of these local governing bodies and Australian government undertakings.

20.21. In Chapter 25 the Committee has recommended that the present exemptions, under sections 23 (e) and 23 (j) (ii), of religious, scientific, charitable and public educational institutions and funds for charitable purposes be continued. There are some other institutions and funds exempted by the provisions of section 23 of the Act which might be thought to be of a similar nature. These are hospitals carried on by an association otherwise than for the profit of its members (section 23 (ea)), medical and hospital benefit funds registered under the National Health Act (section 23 (eb)), and funds established for the purpose of enabling scientific research to be conducted by or in conjunction with a public university or public hospital (section 23 (j) (iii)). The Committee considers that these institutions and funds should continue to be exempt from income tax, though it acknowledges that the exemption may have to be qualified if business activities are carried on which compete with the activities of commercial organisations. This matter is considered in Chapter 25 in relation to charities.

Non-Profit Associations and Societies Formed for Particular Purposes

20.22. The income of trade unions, certain employer associations, friendly societies, cultural and sporting societies, and aviation, agricultural and manufacturing associations is exempt under section 23 (f) (g) and (h). Trade unions, whether registered or

  ― 343 ―
not, and associations of employers or employees registered under Federal or State laws relating to the settlement of industrial disputes are exempt from tax on income from all sources, including income from investments and from any business activities. If, however, an exempt trade union or association is a shareholder in a trading company—indeed the only shareholder—the income derived by the company is taxable in the same way as the business income of any other company carrying on the same kind of business.

20.23. The income of a non-profit friendly society is exempt except where it is the income of a dispensary run by the society. The liability to tax of the income of a friendly society dispensary is covered by Division 9A of Part III of the Act and is dealt with in paragraphs 20.38–20.45. The exemption of the income of a non-profit friendly society extends to income from other business activities and income from investments. ‘Non-profit’ is used here and elsewhere in this chapter to describe an activity not carried on for the purpose of profit or gain to individual members.

20.24. A non-profit society, association or club established for the encouragement of music, art, science or literature is exempt from tax on its income—both investment income and business income. The like income of a non-profit society, association or club established for promoting the development of aviation or of agricultural, pastoral, horticultural, manufacturing or industrial resources, or for the encouragement or promotion of an athletic game or athletic sport in which human beings are the sole participants, is exempt.

20.25. The mutuality principle would apply to prevent at least some of the receipts of a number of the organisations referred to in paragraphs 20.22–20.24 being taxed as income even if those receipts were not made exempt from tax by express provisions. The mutuality principle asserts that a person cannot derive income from dealings with himself. The principle applies notwithstanding that the club or society in which persons are associated is incorporated. The principle may require that subscriptions received from members and some receipts for goods or services supplied to members should not be treated as income. It has been said that for the principle to apply in this way:

‘The cardinal requirement is that all the contributors to the common fund must be entitled to participate in the surplus and that all the participators in the surplus must be contributors to the common fund; in other words, there must be complete identity between the contributors and the participators. If this requirement is satisfied, the particular form which the association takes is immaterial.’note

The Committee understands that it is the policy of the Commissioner to apply the mutuality principle in the assessment of non-profit clubs and societies whose receipts are not made exempt by express provisions. In the result, these societies and clubs are generally subject to tax only on their investment income and on income from trading with non-members. The law has not insisted on the degree of identity which the above quotation might suggest. In the case of a non-profit association there is sufficient identity in the fact that contributions by members which make up, for example, a cash surplus from bar trading will go to assist in financing the facilities and services available to members.

20.26. There should, in the Committee's view, be a limitation of the exemption of the income of the organisations referred to in paragraphs 20.22–20.24. There are undoubtedly cases, at the present time, where some of these organisations are carrying on business operations in competition with taxable persons and, through the exemption from tax, are enjoying an unfair trading advantage. Exemption should continue to be given to income arising from business activities directly related to the carrying out of the purpose for which the organisation was established and which gives it entitlement to exemption but not to other business income. Investment income should in general continue to be exempt, though it would be necessary to deny exemption to income such as interest or rents arising from an investment in a trading entity in which the organisation had an interest exceeding a specified percentage. There would otherwise be an avenue by which exemption might still be obtained in respect of trading income unrelated to the organisation's purpose: inflated interest and rent might be exempt to the organisation and deducted by the trading entity. Dividends might, however, remain exempt in all circumstances since the profits from which they have been paid will have borne tax. If the dividends were not exempt they would, in any event, give rise to an entitlement to rebate which would have the same effect as exemption from tax. The notion of business should, for the purpose of all these proposals, include ownership of real property. In relation to the taxing of receipts from a non-exempt source, the mutuality principle explained earlier would apply where appropriate.

  ― 344 ―

20.27. If the Committee's proposal were adopted, the exemption from tax would continue to be given, for example, to the proceeds of agricultural shows received by agricultural societies and to the proceeds of cricket matches received by cricket associations. The income from portfolio investments of trade unions would be exempt but not income from trading activities.

20.28. It has been submitted that the qualifications imposed by section 23 (g) for exemption of sporting clubs or associations are too restrictive. The exemption was introduced into the law in 1952 to give effect to a recommendation of the Spooner Committee and is similar in its terms to a previous concession in relation to entertainment tax for these organisations. The club or association must have been established for the encouragement or promotion of an athletic game or athletic sport in which human beings are the sole participants. Sports such as cricket, tennis and football are clearly included in the exemption; on the other hand, angling, horse racing, trotting and motor racing are clearly excluded. There are some sports which it might be difficult to categorise. In any case, all sports provide recreation to participants and spectators, and it has become difficult to draw any distinction, on the basis of the degree of commercial activity involved, between sports in which human beings are the sole participants and other sports. In New Zealand, exemption of a similar nature to that now given in Australia by section 23 (g) has been extended, from 31 December 1973, to horse racing, trotting and greyhound racing clubs. The Committee sees some force in the arguments which would support an extension of the exemption of sporting clubs and associations. But it would take the view that questions as to what societies and associations should be exempt are matters of government policy. There may be other organisations with equally strong claims for exemption.

Co-Operative Companies

20.29. Division 9 of Part III of the Act contains provisions setting out the basis of assessment of co-operative companies as defined in that Division. One effect of these provisions is to exclude the application of the mutuality principle in the taxing of such companies. Under the definition, if a company is to qualify as a co-operative company, there must be limits imposed by its rules on the number of shares which a member may hold, quotation of the shares of the company on a stock exchange must be

  ― 345 ―
prohibited, the company must be established to carry on a business having as its primary purpose or purposes one or more of certain stated objects, and 90 per cent of business must be transacted with members. Most co-operatives have objects that relate to primary production activities.

20.30. A co-operative company is entitled to deduct amounts distributed to members by way of rebates or bonuses on business done with the company, and by way of interest or dividends on shares. A co-operative company having as its primary purpose one of the objects stated in the definition may deduct amounts repaid to the Australian or State Governments. Submissions to the Committee have maintained that the special basis of assessment of co-operative companies gives to these companies unfair trading advantages. Other submissions have sought the retention of the present position, and in some cases, complete exemption of co-operative companies.

20.31. It may be helpful in judging the present basis of assessment of co-operative companies to consider how they would be taxed if there were no special provisions. On one approach, a co-operative would be entitled to deductions of rebates and bonuses paid to members, based on business done by members with the co-operative, to the extent that the rebates and bonuses had the character of discounts allowed to members. The fact that the discounts on this basis were paid to customers who were also members would not, it is thought, prevent them being deductible. To the extent, however, that the rebates and bonuses had the character of distributions of profits, they would be treated as dividends paid by the co-operative and, like dividends paid as such, would not be deductible. Interest on borrowings by the company would be deductible.

20.32. On this approach, the taxation of a co-operative company would differ in three respects from taxation under the special provisions:

  • (a) Rebates and bonuses that are not covered by profits made from transactions with members and are therefore paid from investment income of the co-operative or from profits made from transactions with non-members would probably not be deductible.
  • (b) Rebates and bonuses that are not paid from the net gain made by the co-operative from transactions with the particular member to whom they are paid would probably not be deductible.
  • (c) Dividends paid by the co-operative to members would not be deductible.

The third difference may not be thought important, since dividends paid by co-operatives are not significant in amount. The first and second, however, indicate that under the special provisions a measure of concession treatment is given to co-operatives.

20.33. In the absence of the special provisions it would be possible to approach the taxation of a co-operative in terms of the principle of mutuality. On this approach much the same consequences would follow as on the approach that would allow deductions of rebates and bonuses which have the character of discounts. Gains from transactions with members which the rules required should be returned to members as rebates and bonuses would not be treated as income of the co-operative. This would be so even though the gains are returned on a class basis, i.e. the rebate or bonus to a particular member is not necessarily proportional to the gain in fact made

  ― 346 ―
from transactions with him. To this extent the tax treatment would be more favourable than under the discount approach. Investment income and gains from transactions with non-members would be taxed without diminution by deduction of rebates and bonuses paid to members. Again it could be concluded that under the special provisions a measure of concession treatment is given to co-operatives.

20.34. The concession treatment is, in effect, given only to investment income and income from trading with non-members. The extent to which there may be income from non-members is limited by the provisions requiring that 90 per cent of a co-operative's business must be with its members if it is to qualify for the concession treatment.

20.35. If the law were to require that all of a co-operative's business activities must be with its members, or that the co-operative should be taxed on income from business with non-members, as is presently the case in Canada and New Zealand, it would, in effect, be taking away any concession treatment. The Committee appreciates the argument that the concession may give an unfair advantage to a co-operative in competition with other commercial organisations. However, whether any concession treatment now given should be limited—or, for that matter, extended—is a Government policy question. It is important, nonetheless, that the tax treatment of co-operatives be seen in correct perspective.

20.36. The Committee has received submissions requesting that the requirement for 90 per cent of a co-operative's business to be with members be relaxed. It was suggested that if a co-operative undertook secondary activities, possibly of a community nature, in which less than 90 per cent of the business was with the members it would lose the deductions for rebates and bonuses to members while its revenue would continue to be assessable income. The Committee does not feel that the present provisions should have this effect and suggests that it be made clear that any secondary activity would be treated as a separate business for tax purposes. The taxation of this separate business would not affect the concessional treatment of the main activity.

20.37. Co-operative companies may deduct certain loan repayments to governments. On general considerations of equity, the Committee considers that the deduction for repayment of moneys to governments should be withdrawn.

Friendly Society Dispensaries

20.38. Until 1947, the income of a friendly society dispensary was exempt from income tax in the same manner as all other income of a friendly society, as outlined in paragraphs 20.22–20.23. With the introduction of Federal legislation to provide pharmaceutical benefits, under which friendly society dispensaries were allowed to dispense pharmaceutical products for the general public, the question of taxing the income of friendly society dispensaries was considered. In 1952 the Spooner Committee recommended that the taxable income of a friendly society dispensary be deemed to be 10 per cent of:

  • (a) amounts received from the Australian Government under the Pharmaceutical Benefits Act and special charges prescribed by that Act in respect of the supply of pharmaceutical benefits;
  • (b) amounts received from the Australian Government under the National Health Act in respect of the supply of medicines, etc. to pensioners; and
  • (c) proceeds of the sale or supply of medicines and other goods to persons who are not members of a friendly society.

  ― 347 ―

20.39. The recommendation of the Spooner Committee was not adopted. In 1955, however, the present legislation was introduced. Under this a friendly society dispensary is liable to income tax at the concessional rate of 37½ per cent on taxable income exceeding $416, calculated as 10 per cent of:

  • (a) amounts received by it from the Australian Government under the National Health Act 1953 in respect of the supply of pharmaceutical benefits; and
  • (b) the gross proceeds received by it from the sale or supply of medicines and other goods sold or supplied in the ordinary course of business, not including amounts received from a friendly society for the supply of benefits to the members of that friendly society.

This legislation differs from the recommendations of the Spooner Committee in taxing all receipts from members. In 1961, the Ligertwood Committee proposed a basis of assessment of friendly societies which broadly followed the recommendation of the Spooner Committee.

20.40. Submissions have been received from representatives of private pharmacists maintaining that unfair competitive advantages are enjoyed by friendly society dispensaries and that these should be removed. On the other hand, representatives of friendly society dispensaries have complained of being taxed on receipts from members. They also claim that the 10 per cent measure of profit in relation to other dispensary receipts should be reduced to take account of falling profit margins in the pharmaceutical trade since the legislation was enacted in 1955.

20.41. Earlier in this chapter the Committee has considered the basis of taxation of non-profit associations and societies formed for particular purposes. The general basis recommended is that those associations and societies now exempt should be exempt from tax only on business income arising from activities directly related to the carrying out of the purpose for which they were established and which is the justification for their exemption. Income from other business operations should be assessable subject to the application, where appropriate, of the mutuality principle.

20.42. It would follow from this basis of taxation that a friendly society should not enjoy a general exemption from tax on profits from the dispensing of medicines. Where medicines are supplied to members of the society, however, the mutuality principle should apply so as to preclude any profits arising being treated as income. To the extent that the law denies this application of the mutuality principle, a friendly society is denied the tax treatment enjoyed by other mutual associations. There appears to be no basis for distinguishing the supply of liquor by a club to its members from the supply of medicines by a friendly society to its members.

20.43. It follows, in the Committee's view, that the law should adopt the principles of assessment suggested by the Spooner Committee. Accordingly, the Committee recommends that friendly society dispensaries be assessed to tax on the net profit attributable to:

  • (a) amounts received from the Australian Government under the National Health Act for the supply of pharmaceutical benefits and any charges paid by members or by non-members for the supply of those benefits; and
  • (b) the proceeds of the sale or supply of pharmaceutical products, not coming under the pharmaceutical benefits scheme, and other goods to persons who are not members of the friendly society or societies conducting the pharmacy.

      ― 348 ―
    These proposals would exclude from the taxable receipts of the friendly society dispensary, receipts from members for the supply of medicines not subject to pharmaceutical benefits, receipts from members for other goods and receipts from a friendly society for the supply of benefits to the members of that friendly society. It is necessary to include in the receipts subject to tax any amount received from members for medicines supplied which are subject to pharmaceutical benefits, because of the difficulty of apportioning the profit from the supply between the payment received from the Australian Government and the payment received from the member. However, to include any other receipts from members would be a significant departure from the mutuality principle.

20.44. If it is considered that all friendly society dispensaries are in a position to supply figures of profit attributable to the taxable receipts outlined in the previous paragraph, such figures should be the basis of assessment. If this is not thought feasible, a percentage should be applied to those taxable receipts, the percentage being the approximate average net profit of private pharmacists conducting this type of business. If a percentage is to be applied, the present figure of 10 per cent should be reviewed to test whether it is appropriate at the present time.

20.45. On this recommended basis of assessment, friendly society dispensaries should be subject to tax at the normal rates for non-profit companies, that is at 42½ per cent on the first $10,000 of taxable income and at 45 per cent on the remainder. The Committee assumes that because of the narrowing of the base proposed, the increase in the rate of tax will not, generally, increase the amount of tax paid by individual friendly societies.