Commissioner of Taxation v Mercantile Mutual Insurance (Workers Compensation) Ltd S63/1999 [1999] HCATrans 624 (10 December 1999)

IN THE HIGH COURT OF AUSTRALIA

Office of the Registry

Sydney No S63 of 1999

B e t w e e n -

COMMISSIONER OF TAXATION

Applicant

and

MERCANTILE MUTUAL INSURANCE (WORKERS COMPENSATION) LIMITED

Respondent

Office of the Registry

Sydney No S64 of 1999

B e t w e e n -

COMMISSIONER OF TAXATION

Applicant

and

MERCANTILE MUTUAL INSURANCE (AUSTRALIA) LIMITED

Respondent

Applications for special leave to appeal

GAUDRON J

HAYNE J

TRANSCRIPT OF PROCEEDINGS

AT SYDNEY ON FRIDAY, 10 DECEMBER 1999, AT 11.47 AM

Copyright in the High Court of Australia

___________________

MR D.H. BLOOM, QC: May it please the Court, I appear with my learned friend, MR K.M. CONNOR, for the applicant. (instructed by Australian Government Solicitor)

MR R.F. EDMONDS, SC: May it please the Court, I appear with my learned friend, MR B.J. SULLIVAN, SC, for the respondent. (instructed by Ernst & Young Law)

GAUDRON J: This time we shall hear from you, Mr Bloom.

MR BLOOM: Thank you, your Honour. It would be convenient if your Honours had a copy of the Court's judgment in Coles Myer 176 CLR as well as the application book in order that I might take you quickly to the central issue. If your Honours would turn first to page 663, there is a passage there in the judgment of the majority, about point 3:

But it is not enough to establish the existence of a loss or outgoing actually incurred. It must be a loss or outgoing of a revenue character and it must be properly referable to the year of income in question.

GAUDRON J: In this case you do not have any difficulty relating it to the year, do you? There are claims made in that year, or - they are claims notified in that year, or they are events that have happened in that year which will give rise to a liability.

MR BLOOM: It is a question of quantum. As Sir Owen Dixon pointed out in a foreign exchange case, Armco, which we referred your Honours to, if one has a debt for trading stock incurred in year one, which is payable subsequently in foreign currency, and an additional amount of Australian dollars is needed in that later year to discharge a debt, then the difference is a deduction in the later year because it is referable to that later year, notwithstanding in truth the incurring happens in the earlier year, and that is what this case is about. It is a question of what part - - -

HAYNE J: Is that right? We start, do we not, from the proposition that in the year of income in question claims have been incurred but not reported.

MR BLOOM: Yes, your Honour.

HAYNE J: An amount must be taken to account in that year in respect of the IBNR events. So far so good?

MR BLOOM: So far.

HAYNE J: The question becomes how much should be taken to account in that year.

MR BLOOM: Quite.

HAYNE J: The debate is, do you take to account the outgoing that would be incurred in that year, necessarily an estimate, to meet IBNRs, or do you take to account some present value or adjusted value for IBNRs?

MR BLOOM: No, that may be one view of it. Another way, and the way we would prefer to put it is this: do you take into account the amount which according to the matching principle and the accountants upon which this whole thing is based is set aside in the accounts for that year, or do you increase that amount for deduction purposes only by reference to inflation that will occur between the date of incurring the outgoing and paying it?

HAYNE J: The item reflected in the accounts represents a discounted amount, does it?

MR BLOOM: It represents the amount set aside.

HAYNE J: I understand that. Is it a discounted amount?

MR BLOOM: Yes, it is.

HAYNE J: The question is whether it is right to discount, as the accounts would reflect, or whether it is right - this is putting it, perhaps, too loosely - to take face value?

MR BLOOM: The difficulty I had and why I did not answer your Honour so promptly is that in fact the amount which the accountants set aside in the accounts is inflated and discounted, and what they do is they leave off the discount aspect but they leave the inflated in.

HAYNE J: They make various adjustments.

MR BLOOM: Yes. Your Honours, in relation to these particular deductions, the cases which stand as - and we do not challenge them - as authority for the proposition that one should have the deduction, two Victorian cases, RACV and Commercial Union, are cases that base the entitlement to the deduction upon the accounting principle. They were interpreted, both of them, by Justice McHugh in Coles Myer in this Court, as authorising deductibility for the amount set aside. He says as much at page 678 in Coles Myer at the last paragraph on the page:

Furthermore, if two insurance cases correctly apply ratio decidendi of James Flood and Nilsen Development Laboratories, an amount may be deductible under s 51(1) even though the legal liability which it represents is a matter of estimation and not proof. In RACV.....Menhennitt J, sitting in the Supreme Court of Victoria, held that, pursuant to the provisions of section 51(1), an insurer was entitled to a deduction in respect of amounts put aside in the income year to meet compulsory third party claims -

et cetera. Likewise, IBNR, the amount put aside.

HAYNE J: On any view, we are in the realm of estimation for IBNRs. The question is, which estimate?

MR BLOOM: We may be wrong in this, but we see the referability principle, if I may call it a principle, as there to prevent exactly the sort of distortion which is acknowledge here, and Justice Sackville points out the distortion is significant. Indeed, it is worth in terms, as we understand it, around a billion dollars.

GAUDRON J: We do not know if it is a distortion.

MR BLOOM: Justice Sackville certainly called it that.

GAUDRON J: Yes.

MR BLOOM: It is a nice emotive word.

GAUDRON J: It may prove to be a distortion; it may prove to be otherwise.

HAYNE J: But you are necessarily estimating a sum to be set against the income of the year in question, are we not?

MR BLOOM: Yes.

HAYNE J: We are therefore concerned with the estimation of a sum that, if you like, matches the income of the year in question in the sense that it is a sum properly taken to account against the income of that year rather than the income of a later year. Why does the matching principle take you further to tell you how to make the estimation?

MR BLOOM: Because the matching principle being a pure accounting principle, and being referred to again by the majority in Coles Myer at 665 as representing the statutory principle in relation to this question of referability, that matching principle gives you a deduction, as Justice McHugh noted, for the amount set aside. The question is, for tax purposes do you add to that the inflation you expect to encounter between the date upon which you incurred a liability and the date in which you will discharge it; and if so, can you add back into the year of income an amount equal to that inflation, because that is exactly what has happened here. The accounting provision, the one which, for the purpose of giving it true refection of the accounts of the companies, has been increased by the inflation expected to be met between the date of the year of income and the date upon which the amount will ultimately be discharged. So inflation is added in. We say inflation is, in accordance with Coles Myer, properly referable to the years in which the inflation happens, and that is for tax purposes as well.

HAYNE J: To speak of inflation being added in may obscure the fact, may it not, that what is being done is simply to take dollar sums regardless of purchasing power at the time of receipt or outlay.

MR BLOOM: But your Honour, the same must be true about foreign exchange. It must be possible to speak to the pundits and to get some sort of estimate as to what the amount will be required to discharge foreign exchange debts in the future, and yet the cases are clear, that any increase in the amount required to discharge it over its value at the date the debt is incurred belongs to that subsequent year. It is no different, with respect, to inflation in the amount which the cases upon which my learned friend relies to get a deduction in the first place authorise only deduction of the amount set aside.

HAYNE J: Do you have to challenge in this case the adoption of historic cost and similar principles?

MR BLOOM: I do not have to, no.

GAUDRON J: Why not? I think that is exactly what you are doing.

MR BLOOM: No. Your Honour may well be right, but one had thought - - -

HAYNE J: At the moment I think her Honour is; so tell me why she is not.

MR BLOOM: Her Honour always is.

HAYNE J: By definition, yes.

MR BLOOM: From where I stand, anyway. We come at it a different way. This referability principle means something. It has been added on top of the concept of incurring.

GAUDRON J: Who say it - it is a sentence in a case which was far removed from this.

MR BLOOM: It is more than a sentence, with respect, your Honour. If one goes over to page 665 there is a couple of pages devoted to it. Then Justice Deane gives a similar approach. But, at 665 under the heading "What is the amount of taxpayer's loss or outgoing referable to the year of income?" the Court makes it abundantly clear that you first find an outgoing incurred, you then have to determine two more things: whether it is revenue and whether it is referable entirely to the year of income.

GAUDRON J: But again, there is not any difficulty about making it referable in this case, because it relates, it refers exactly to liabilities arising in that year.

MR BLOOM: Yes, your Honour.

GAUDRON J: So, it is not a question of referability. It is purely a question of calculation and that is why I say it seems to me you are exactly in the territory of historical cost accounting.

MR BLOOM: Your Honour, in Coles Myer, itself, the full amount of the liability for the discount was incurred in the year in which that discount took place, it was fallen upon in that year. But the Court still went on to say "What part of the liability which we find is unquestionably incurred is referable to the year of income?". Justice Deane gives an example which he accepts as extreme at page 672, but it does assist in what I am endeavouring to show your Honours. It is about point 5 of the page:

If, to take an extreme example, a taxpayer were to acquire a valuable item of stock-in-trade -

Do your Honours see that?

GAUDRON J: Yes.

MR BLOOM: Now, he would put it, over at page 673 at about point 3, going back to his example, as a need to take into account:

the fact that no interest was payable -

on the debt in the first place. That comes back to the way your Honour put it. But, the majority, back at 665 to 666 put it in terms of profit and a need to work out what part of an outgoing admittedly incurred. So what part of an existing liability is truly referable to the period with which one is concerned. They put it in terms of avoiding distortion, over at page 666.

HAYNE J: How is it that you say inflation element claims is properly referable to a later year of income?

MR BLOOM: If I could take your Honours to the passages - they are only three very short passages in the appeal book which deal with the issue. Firstly, at page 50 in the judgment of the presiding judge, Justice Hill, line 6:

It is referred to as "inflated" because the figure arrived at took into account the changing value of money where claims were to be paid in the future. Thus the calculation took into account expected rates of inflation.

Then at 79 in the judgment of Justice Hely, he sets out the Commissioner's argument at line 39:

A deduction for the effects of inflation on the quantum of the claim is allowable in the years in which the inflationary effects are encountered, rather than in the financial period in which the premium is received and the outstanding claims liability first assessed.

Over the page at line 109 he says, after a reference to Australia & New Zealand Banking Group:

there is no reason for leaving out of account the effect of the passage of time before the claim is likely to be paid and of inflation during that period -

So, that is what we are talking about. That is all we are talking about.

HAYNE J: But you seek to segment the claim into its current value and its inflated value, do you not?

MR BLOOM: The accountants have done that for us. The accountants have said we set aside - - -

HAYNE J: But that is an essential step in your argument, is it not? And how is this inflated element of the argument properly attributed to the later year?

MR BLOOM: It represents inflation to be encountered in those later years. It is the estimate of the amount by which the amount set aside, in effect, is going to increase in those later years.

HAYNE J: That is to say, in this year the insurer says, "I believe I have incurred a claim not yet reported. It is likely that claim will be paid out in five years' time. In five years' time for a broken leg, whereas today I would pay $10,000, in five years' time I will have to pay $15,000. I will mark the IBNR claim as $15,000 when I am drawing my tax return. How is the $5,000 fallen upon in the five year hence year of income and the $10,000 sum fallen upon in this year of income?

MR BLOOM: It is fallen upon progressively. Justice Newton, in Commercial Union, dealt with this. At page 47 in the application book the relevant passage is set out. Just below line 31:

"In my opinion it must now be accepted that the words `the assessable income' in s 51 mean assessable income of the taxpayer generally.....Hence, in my opinion, just as an estimated provision for outstanding claims, including claims incurred but not reported, arising from insurances current in one year, is an allowable deduction under s 51 in calculating the insurer's taxable income for that year.....so an increase in the estimate at the end of any subsequent year for any of those claims which are then still outstanding, is an allowable deduction in calculating the insurer's taxable income for that subsequent year.

That is the principle for which we argue. We say you take the amount set aside, as Justice McHugh referred to it, that is your deduction in this year. Increases in the estimate as you go on year by year are deductions of those years, just like the foreign exchange debts.

GAUDRON J: Except that your liabilities are not incurred in that year.

MR BLOOM: But so they were in Coles Myer.

GAUDRON J: In Coles Myer you were talking - I know. Everybody wants to take Coles Myer and inflate it into some overarching principle that works right across section 51. You were talking about "the recurrent cost of acquiring working or circulating capital" - 665.

MR BLOOM: Yes, your Honour.

GAUDRON J: We are not talking in that area at all in this case. We are talking about liabilities incurred in a particular year.

MR BLOOM: But we are talking about a liability which will increase over a period of time, and we are talking about whether the increase in it - because we are not talking about a fixed liability here, but it is one that will increase like the foreign exchange situation - is that increase referable, as Sir Owen Dixon said, as Justice Newton said, to the subsequent period, as we would contend, or is that increase a liability of the earlier period. In Armco, your Honours I am sure have looked at that - it is at page 618 of 76 CLR at point 5 of the page, and he is dealing with the debt for trading stock which falls to be discharged in a later year, and it is a foreign currency situation, and he says:

The comparison made between the beginning and end of an accounting period means that stock in trade and purchases are taken into account not by reference to what is actually paid for them, but according to the value assigned to the one and the liability incurred in acquiring the other. That is done, of course, entirely independently of the period within which the actual disbursement of money is made to discharge the liability. If, as is commonly the case, the amount of the liability is fixed and incapable of subsequent variation, the disbursement itself when ever made could never matter for the purpose of computing profit or loss in that or any subsequent period. But if for any reason the amount is capable of changing, as is the case when the indebtedness is in a foreign currency and the rate of exchange may alter, a further question arises. If the change takes place in a subsequent period and actual payment is then made, is the increase or decrease, as the case may be, to be attributed to the prior period and the net profit or loss reassessed? Obviously not. It is to be taken in as an item belonging to -

we say "referable to" means the same -

the subsequent period; for the reason that, with continuing trading, when increases beyond the estimates by which assets and liabilities are carried out of one period into the next occur, they must be treated as incidents of the system and they must be regarded as belonging to the period in which they accrue or are realized.

If I may say this finally, your Honours, there is a misunderstanding of Coles Myer. If for no other reason, this is a good vehicle at least to clarify what this referability principle is. It was quite clearly misunderstood, in our respectful submission, by the judges in this case. Certainly Justice Hill, after referring the passages to which I have taken your Honours in the judgment of the majority, misunderstood it to be a principle that affected the question of whether or not an outgoing was incurred, rather than a question of how much of an outgoing, admittedly incurred, was referable to relevant periods.

It is a matter which does affect the whole of section 51(1). There have been doubts about Coles Myer in other Full Federal Court cases such as Woolcombers, and it is a matter of some difficulty, and for that reason alone we would we would ask that special leave be granted. If your Honours please.

GAUDRON J: Thank you, Mr Bloom. We need not trouble the respondent in this case.

We are of the view that no error of principle is to be discerned in the approach of the Federal Court in these matters. Accordingly, in each case special leave is refused. It is refused with costs, costs having been the subject of written submissions.

AT 12.08 PM THE MATTER WAS CONCLUDED