27 June 2007 Internal T.I. 2006-0167351I7 - CRL - Contingent Liabilities

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: 1. Should a contingent liability of the taxpayer in connection with an assumption reinsurance agreement, be included in determining the taxpayer's Canadian Reserve Liabilities ("CRL")?

2. Is the interest that accrued on the contingent liability, and that eventually became payable by the taxpayer to the reinsurer, deductible by the taxpayer in computing its income for the year in which the interest becomes payable?

Position: There is support for audit's position to include the contingent liability in the computation of the CRL and where the amount is included in CRL, the interest should be deductible in the year it becomes payable (ie. no longer contingent), pursuant to subparagraph 138(5)(b)(iii).

Reasons: The words of the CRL definition and subparagraph 138(5)(b)(iii)

 								June 27, 2007

XXXXXXXXXX  TSO						HEADQUARTERS
Insurance Industry Specialist Services		Income Tax Rulings
Insurance Industry Specialist	  			Directorate
								Alison Campbell
(613) 948-5125
Attention:  XXXXXXXXXX
								2006-016735

Re: Contingent Liability and Computation of CRL

This is in reply to your memorandum of January 16, 2006 and subsequent discussions and submissions of April 24, 2007. You had requested our views on the inclusion of a contingent liability amount in the taxpayer's Canadian Reserve Liability ("CRL") as defined in subsection 2400(1) of the Regulations to the Income Tax Act (the "Regulations").

Our understanding of the relevant facts in this case is as follows:

1. XXXXXXXXXX (the "Taxpayer") is a non-resident property and casualty insurer that carries on business in Canada through a branch.

2. The Taxpayer entered into a transfer and assumption reinsurance arrangement (the "Reinsurance Agreement") with a Canadian resident property and casualty insurer (the "Reinsurer"), under which the Taxpayer agreed to sell its personal lines of business to the Reinsurer. The Reinsurance Agreement was effective XXXXXXXXXX.

3. Under the terms of the Reinsurance Agreement the Taxpayer agreed to make a payment to the reinsurer if, at a certain specified time (in a subsequent taxation year) after the effective date of the Reinsurance Agreement, the claims experience under the transferred policies was worse than anticipated at the time that the original purchase price for the business was determined (Articles XXXXXXXXXX of the Reinsurance Agreement). The Reinsurance Agreement also provided that if the claims experience was better than anticipated, the Reinsurer would be required to make a payment to the Taxpayer.

4. Based on information available to the Taxpayer at XXXXXXXXXX, the Taxpayer calculated that it had a contingent liability owed to the Reinsurer of approximately $XXXXXXXXXX (the "Contingent Liability") as a result of adverse experience under the transferred policies since XXXXXXXXXX. The $XXXXXXXXXX Contingent Liability was disclosed among "Other Liabilities" in the Taxpayer's annual report to OSFI for the year ended XXXXXXXXXX.

5. The Reinsurance Agreement also provided that any amount that was payable by one party to the other party as a result of claims experience being different from anticipated at the time of the effective date of the Reinsurance Agreement, would accrue interest from XXXXXXXXXX.

6. In calculating its income for accounting purposes for the year ended XXXXXXXXXX, the Taxpayer had deducted the amount of the Contingent Liability and the interest related thereto. In computing its tax liability for the taxation year ended XXXXXXXXXX, the Taxpayer added back the amount of the Contingent Liability and the interest thereon, on the basis that contingent liabilities are not deductible in computing income under Part I of the Income Tax Act (the "Act") by virtue of paragraph 18(1)(e) of the Act.

7. In computing its CRL for the taxation years ended XXXXXXXXXX, the Taxpayer did not include the amount of the Contingent Liability.

8. In computing its income for its taxation year ended XXXXXXXXXX, the Taxpayer deducted the interest that had accrued on the Contingent Liability and had become payable in the year.

Taxpayer's Position

It is our understanding that the Taxpayer's position is that the Contingent Liability is not required to be included in computing CRL because it is not a "liability or reserve" and it is not "in respect of" fire insurance policies on Canadian property, or in respect of other insurance policies covering risks ordinarily within Canada at the time the policy was issued or effected (underlined portion hereinafter referred to as "policies covering Canadian risks"). In regards to the phrase "in respect of" policies covering Canadian risks in the CRL definition in subsection 2400(1) of the Regulations, the Taxpayer is of the view that only those policies under which the Taxpayer has an obligation to the policyholders are within the scope of the definition. Since the Reinsurer is now responsible to the policyholders under the transferred policies and the Taxpayer's obligation is one owed to the Reinsurer, it is the Taxpayer's view that the Contingent Liability is not included in its CRL.

We also understand that in XXXXXXXXXX, when the Contingent Liability became an amount payable by the Taxpayer to the Reinsurer, the Taxpayer in computing its income deducted the accrued interest on the amount.

Audit's Position

It is your view that the phrase "in respect of" policies covering Canadian risks is to be given its widest possible interpretation and since the Contingent Liability is computed with reference to the claims experience under insurance policies covering Canadian risks and is owed to the Reinsurer in connection with the transfer, by the Taxpayer, of insurance policies covering Canadian risks the Contingent Liability is to be included in the computation of CRL for the Taxpayer's taxation years ended XXXXXXXXXX.

With respect to the interest that accrued on the Contingent Liability, it is your view that in determining whether the interest is deductible the inter-play between the definition of CRL in subsection 2400(1) of the Regulations and subparagraph 138(5)(b)(iii) of the Act must be considered.

Our Comments

We agree that the relevant provisions of the Act and Regulations that need to be considered are the CRL definition in subsection 2400(1) of the Regulations and subparagraph 138(5)(b)(iii) of the Act. With respect to the Taxpayer's situation, the definition of CRL in subsection 2400(1) of the Regulations provides that the CRL of the Taxpayer as at the end of a taxation year means the total of the Taxpayer's liabilities and reserves (other than liabilities and reserves in respect of a segregated fund) in respect of;

b) fire insurance policies issued or effected in respect of property situated in Canada; or

c) insurance policies of any other class covering risks ordinarily within Canada at the time the policy was issued or effected.

For purposes of claiming a deduction in respect of the interest that accrued on the Contingent Liability, subparagraph 138(5)(b)(iii) of the Act provides that, notwithstanding any other provision of the Act, no deduction may be made under paragraph 20(1)(c) or (d) of the Act, in computing the Taxpayer's income for a taxation year from carrying on an insurance business in Canada, except in respect of interest on deposits received or other amounts held by the Taxpayer that arose in connection with policies insuring Canadian risks.

It is our view, based on legal dictionary definitions as well as case law, that the phrase "liability or reserve" is sufficiently broad so as to include contingent liabilities. The Taxpayer had cited the Federal Court of Appeal decision in Wawang Forest Products Limited and Nerak Contractors Inc. v. The Queen, (2001 DTC 5212) as support for its position that a "contingent liability" is not a "liability" for purposes of the Act. We respectfully disagree with their interpretation of the case. The Wawang case dealt with the deductibility of contractor holdbacks and the court was asked to determine whether the expenses were "incurred" in the year claimed for purposes of paragraph 18(1)(a) of the Act or were "contingent liabilities" in the year and therefore precluded from being deducted pursuant to paragraph 18(1)(e) of the Act. In its analysis, of whether the expenses were "incurred" or were "contingent", the court looked at whether the liability to pay the amount was an "absolute" or "legal" liability or a "contingent" liability. The court did not, in our view, hold that a "contingent liability" is not a "liability" for purposes of the Act.

The Taxpayer has argued in their submissions that the CRL definition only applies to liabilities and reserves in respect of the policies described in paragraphs (b) and (c) of the definition, where the Taxpayer is directly liable to the policyholders of the policies. It is their view that although the word "its" was removed from the phrase "in respect of its policies" in the CRL definition, when the definition was amended effective for 1999 and subsequent taxation years, the provision should still be read as though the word "its" remained because the Department of Finance Technical Notes included the word "its". The words in the Technical Notes were the same as the legislation read prior to the amendment. It is our view that the CRL definition is to be read without the insertion of the word "its" as had appeared in the previous version of the legislation. It is our understanding that the word "its" was intentionally removed from the definition to clarify that reserves carried by insurers that had assumed risks under indemnity reinsurance contracts were to be included in the computation of that assuming insurer's CRL. Although the Department of Finance Technical Notes do refer to "its policies" in the CRL definition description, and the Technical Notes may be referred to as an interpretive aid where the wording of a provision is unclear, the Technical Notes do not override the wording of the statute itself.

While we do not agree that the CRL definition should be interpreted as narrowly as suggested by the Taxpayer, we do believe that there is some merit to the argument that the CRL definition should not be interpreted so broadly that all liabilities and reserves would be said to be "in respect of" insurance policies. The distinction that is made in the "weighted Canadian liabilities" and "weighted total liabilities" definitions in subsection 2400(1) of the Regulations, between liabilities and reserves that are in respect of insurance policies and those that are in respect of the insurance business, suggests that the CRL definition should not be read so broadly that all liabilities and reserves of an insurer would be included in CRL. Given that, in this case, the amount of the Contingent Liability was determined specifically with reference to the claims experience under policies insuring Canadian risks, we believe there is a reasonable argument that the Contingent Liability is more properly categorized as a liability or reserve in respect of insurance policies as opposed to a liability or reserve in respect of the insurance business.

We have also considered the relationship between the phrase "in respect of insurance policies" in the CRL definition in subsection 2400(1) of the Regulations and the phrase "in connection with policies insuring Canadian risks" in subparagraph 138(5)(b)(iii) of the Act. As you noted in your submission, the leading case on the meaning of the phrase "in respect of" is the decision by the Supreme Court of Canada in Norwegijick v. The Queen, (83 DTC 5041), wherein it was said,

"The words "in respect of" are, in my opinion, of the widest possible scope. They import such meanings as "in relation to", "with reference to" or "in connection with". The phrase "in respect of" is probably the widest of any expression intended to convey some connection between two related subject matters."

It is our view, that the phrase "in respect of" is at least as broad, if not broader than the phrase "in connection with". Accordingly, if an item is said to be "in connection with" another item, then it must also therefore be "in respect of" that other item. In order for the interest that accrued on the Contingent Liability to be deductible by the Taxpayer, the interest must have arisen "in connection with" insurance policies insuring Canadian risks. It would in our view be inconsistent to accept the position that the Contingent Liability is not in respect of policies covering Canadian risks and yet accept that the interest that accrued on that Contingent Liability arose in connection with insurance policies covering Canadian risks.

Conclusion

Based on the foregoing analysis, we are of the view that there is support for your position that the Contingent Liability should be included in the CRL of the Taxpayer. If the Contingent Liability is included in the Taxpayer's CRL, we are also of the view that the Taxpayer would be entitled to deduct a reasonable amount in respect of the interest that was ultimately paid to the Reinsurer under the terms of the Reinsurance Agreement.

However, as discussed, if the Taxpayer is prepared to object to the inclusion of the Contingent Liability in the calculation of its CRL for its XXXXXXXXXX taxation years on the basis that it is not in respect of insurance policies insuring Canadian risks, it is our view that you have a reasonable basis to reassess the Taxpayer's XXXXXXXXXX taxation year to deny the deduction of interest claimed on the basis of subparagraph 138(5)(b)(iii) of the Act.

This memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. You should make requests for this latter version to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

We trust that our comments will be of assistance.

Yours truly,

F. Lee Workman
Manager
Charitable and Financial Institution Sectors
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch