Co-operator's General Insurance Co. v. MNR, 93 DTC 303, [1993] 1 CTC 2316 (TCC)

Brulé, T.C.C.J.:—These appeals involve reassessments by the Minister of National Revenue ("Minister") wherein the appellant was disallowed certain deductions in respect of premiums paid to various reinsurers.

Facts

The appellant's company is in the property and casualty insurance business. Its year end is December 31. Co-operators General Insurance Company ("Cooperators") was formed by the amalgamation in February, 1983 of Co-operators Insurance Association and Co-operators Fire and Casualty Company.

For the three years under appeal, 1982, 1983 and 1984 the following amounts of disallowed deductions are set out.

In 1982 the Minister disallowed a deduction of $1,214,087 of the total maximum premium of $2,718,937 claimed by the appellant. He determined that only $1,504,850 in reinsurance premium was payable in the 1982 year. In so reassessing, he denied that the amount of $1,214,087 was an expense incurred in the 1982 taxation year.

In 1983 and 1985 Co-operators maximum premium was $4,947,378 and $3,505,857 for its 1983 and 1985 treaty years, respectively. For both Co-operators' 1983 and 1985 taxation years, the Minister disallowed the deduction of additional premium amounts above its annual minimum premium. As a result, a deduction of $4,215,077 in the computation of income was disallowed in 1983 and a deduction of $962,937 as a carry-back of non-capital loss from Cooperators' 1985 taxation year was also disallowed.

In the 1984 Co-operators’ taxation year the Minister disallowed the amount of $1,802,223 as a deduction in the computation of income. After allowance was made for reinsurance premiums for prior treaty years, the net amount of $1,802,223 was disallowed. In other words, the Minister disallowed any additional premiums for the 1984 treaty year above the minimum premium amount.

In the taxation years under appeal, the appellant entered into reinsurance contracts, or treaties as they are called, with various reinsurers. These reinsurance treaties are of a particular type known commonly in the insurance industry as "experience rated” or" swing rated” reinsurance, as opposed to flat rated reinsurance. In the 1970s and 1980s, amounts of personal injury damages escalated due to social inflation and the value of court awards. The importance of experience rated reinsurance treaties is the sharing of part of the risk and the ability to increase policy limits to satisfy the needs of the policy holders.

These experience rated reinsurance treaties provide for reinsurance premiums calculated in accordance with a formula. The formula prescribes a minimum and a maximum premium for each year, both calculated as a percentage of“ "gross net earned premium income" which is premium income to Co-operators less amounts ceded to reinsurers. The formula provides for additional premium above the minimum up to the maximum premium level, if Co-operators' excess of loss claims exceed an aggregate deductible for that year.

Excess of loss is any loss above a predetermined retention limit. Any amount below the retention limit would be a loss for which the appellant would remain liable. For 1982 and 1983, excess of loss was any amount above its $400,000 retention limit in respect of any one claim for which Co-operators was liable. In 1984 the retention limit for any one claim was $500,000. If an estimate of a claim was less than the retention limit, the appellant could not have potential recovery from its reinsurers. It is "potential recovery" because there was an aggregate deductible; although reinsurance coverage applied to each Claim in excess of the retention limit, the reinsurer was still not liable for any reinsurance until the aggregate amounts of excess of loss claims exceed a certain stated amount for all claims made in respect of the treaty year. The aggregate deductibles were $500,000 for 1982, $1,500,00 for 1983 and 1984. In other words, the appellant reinsured a certain portion of the liability which might accrue on its policies with its insured.

The annual premium payable is based on the aggregate claims experience of the insurer for the treaty year. As mentioned above, this annual premium has a stated minimum premium amount and a stated maximum premium amount. The treaty requires that the minimum premium amount is due and payable by the appellant during the treaty year in quarterly instalments. Additional premiums up to the maximum premium amount, referred to as the “burning cost", are required to be paid if excess loss claims exceeds an aggregate deductible. Once the aggregate claims experience exceeds the maximum premium, the reinsurer is liable for any additional loss on the excess of loss claims.

Loading is an agreed increase in the burning cost intended to cover the reinsurers’ own acquisition costs, management expenses, profit, and risk assumption. Loading increases in accordance with the increase in the excess of loss claim liabilities.

When claims arise they are investigated and become, if valid, claims incurred. Once all the claims for a treaty year have been reported and estimated, excess of claims would be identified which would be used to calculate any additional premium for that treaty year. The additional premium calculation is carried out shortly after the treaty year is over. If the estimated aggregate of all the excess claims in the year exceeded the aggregate deductible, then an additional premium amount becomes due and payable to the reinsurer.

The point at which the risk transfers from the ceding company (here Cooperators) to the reinsurer is when the maximum premium amount is reached. The reinsurer then assumes the responsibility for any additional loss or any increase in the loss. There is no transfer of risk between the minimum premium amount and the maximum premium amount. Therefore, it is referred to as the mere "trading of dollars” before the maximum premium is triggered.

This additional premium calculation for a particular treaty year continues annually until all claims have been settled for that year. For example, if after the treaty year, a claim is settled for a greater or lessor amount than as previously estimated, then the calculation of additional premium for that treaty year would have to be adjusted. Consequently, depending on the loss experience, subsequent adjustments to the premium calculation may require that the reinsurers return certain portions of burning cost and loading.

In the insurance industry, an automobile portfolio produces very large third party liability claims and for Co-operators it makes up approximately 70 per cent of the total claims. Co-operators becomes liable for an accident injury claim when the accident occurs. It is not able to immediately determine what the ultimate damages are going to be; the full extent of the injuries may not be determined for a period of years. It normally takes five to seven years to settle a personal injury claim. There is tremendous reliance on estimates in the interim. Estimates are the basis of the insurance business.

In its 1982 balance sheet, Co-operators included the maximum premium amount as a liability under the name of "accounts payable and accrued charges". In its 1983 and 1984 balance sheet, the maximum premium amount was included as a liability under "due to reinsurers". In all years under appeal, they were not reported as" provision for unpaid claims" or generally as a claims reserve.

Co-operators deducted the maximum premium in each treaty year because their past experience showed that the maximum premium would be reached. In 1979, 1980 and 1981, the maximum premium level was reached and paid. These prior years' experiences were used to determine future reinsurance projected costs.

The insurance industry is regulated by the Department of Insurance ("Department") by virtue of the Canadian and British Insurance Act, R.S.C. 1985,

c. 1-12. Insurance companies are required to file an annual report as provided by the Superintendent of Insurance. Estimates are used in reporting items to the Department of Insurance. The Department examines annual reports to check for compliance with insurance regulations and whether the insurer is solvent. Insurance companies are required to show a provision for "unpaid claims” representing the amount they estimate might have to pay to settle their policy claims. In 1982, the biggest liability for the year was provision for unpaid claims. There was evidence which showed that the Department believed that Co-operators "company reserves" or claim reserves were too low. This, how- ever, has no relevance to the legal issue of whether the maximum premium could be deducted as an expense incurred. There were no instructions from the Department to insurers as to how to deal with the income tax treatment of the maximum premium under an experience rated reinsurance treaty. There is no relevant communication from the Department concerning the maximum premium.

Account #291 was a bank account set up by the appellant to deal with additional premium or burning cost liability. Minimum premium liability was set up in an accounts payable account.

Issue

The appellant argues that the maximum premiums for its 1982, 1983 and 1984 treaty years were payable at the end of each treaty year and accordingly, the Minister erred in disallowing the full amount of deductions claimed. The Minister argues that the maximum premiums were not yet payable at the end of each treaty year and the appellant could not therefore deduct pursuant to paragraph 18(1)(a) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") any amount above the actual premiums payable in accordance with their premium calculation formula. Other provisions of the Act also do not assist the appellant.

The sole issue involved in these appeals is whether or not the appellant was correct in each year under appeal to deduct the maximum premium claiming such was payable and was not a contingency but a liability.

Appellant's position

Counsel for the appellant presented to the Court thorough and well developed arguments, one principal one and the other in the alternative. The first involved the maximum premium and its deductibility, and whether it is a contingency or not, and whether it is a reserve or not.

The alternative or second argument is that the maximum premium is an amount that should be allowed under paragraph 20(7)(c) of the Act as prescribed in Regulation 1400(e).

Counsel commenced to show that the appellant had a right to deductibility of the maximum premium with a reference to subsection 9(1) of the Act and the generally accepted accounting principles ("GAAP") from which profit may be computed. Subsection 9(1) provides:

Subject to this Part, a taxpayer's income for a taxation year from a business or property is his profit therefrom for the year.

Counsel for the appellant stressed the fact that as a property and casualty insurer it necessarily relies on estimates. He argued that the commercial realities of the insurance business with its lengthy loss development and extensive reliance on estimates are relevant when considering the applicable provisions of the Act. In support of this proposition there was cited, among others, the following cases:

Johns-Manville Canada Inc. v. The Queen, [1985] 2 S.C.R. 46, [1985] 2 C.T.C. 111, 85 D.T.C. 5373;

Canada v. Nowsco Well Service Ltd., [1990] 1 C.T.C. 416, 90 D.T.C. 6312 (F.C.A.);

Time Motors Ltd. v. M.N.R., [1969] S.C.R. 501, [1969] C.T.C. 190, 69 D.T.C. 5149; and

Maritime Telegraph and Telephone Co. v. Canada, [1991] 1 C.T.C. 28, 91 D.T.C. 5038 (F.C.T.D.); aff'd [1992] 1 C.T.C. 264, 92 D.T.C. 6191 (F.C.A.).

It was also suggested that the strict adherence to the matching principle will represent the truest picture of its income; in West Kootenay Power and Light Co. v. Canada, [1992] 1 C.T.C. 15, 92 D.T.C. 6023, at page 22 (D.T.C. 6028) (F.C.A.), MacGuigan, J.A. stated:

In my view, it would be undesirable to establish an absolute requirement that there must always be conformity between financial statements and tax returns . . . The approved principle is that whichever method presents the truer picture” of a taxpayer’s revenue, which more fairly and accurately portrays income, and which "matches" revenue and expenditure, if one method does, is the one that must be followed.

This was also stated in the Maritime Telegraph case, supra. Since previous years experience showed that the maximum premium eventually became payable, for the purpose of proper matching and representing a "truer picture” of the taxpayer's revenue, the maximum premium for the treaty year was deducted in the treaty year. Consequently, the appellant submits that neither paragraph 18(1)(a) nor 18(1)(e) applies to preclude the deduction in accordance with general accounting principles.

Paragraph 18(1)(a) provides that in computing income of a taxpayer from a business or property, no deduction shall be made in respect of “an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property". And, a contingent liability has been defined as liability "dependent for its existence upon an uncertain future event" (Newfoundland Light & Power Co. v. Canada, [1990] 1 C.T.C. 229, 90 D.T.C. 6166, at page 239 (D.T.C. 6173) (F.C.A.)).

Counsel argued that according to GAAP the maximum premium amount was not a contingent liability because in its view the critical events had occurred in the year and that critical events were the accidents which produced excess of loss claims. The accidents themselves create liability for additional premiums, and therefore the cost of reinsurance should be included in the year the accidents occur.

Argument was made that these appeals are similar to Day & Ross Ltd. v. The Queen, [1976] C.T.C. 707, 76 D.T.C. 6433 (F.C.T.D.). In that case the taxpayer carried on a trucking business. The taxpayer insured itself for claims for damages. At pages 710-11 (D.T.C. 6434-35), Dubé, J., described the circumstances in which insurance premiums were payable to its insurer, Lloyd's:

They were payable to Lloyd’s, London, England under a complex 3-year policy, from May I, 1967 to May 1, 1970. The coverage included cargo claims, collision damage to tractors and trailers, and public liability and property damage. The calculation of premiums is based on a rather complex method which takes into account the total incurred losses actually paid during the year, plus an amount established by Lloyd's as being its probable liability for claims arising during that year but unpaid. The formula is set out as follows in Endorsement No 1 to the policy:

“It is further agreed that this insurance is granted in consideration of the payment of an annual deposit premium of $60,000 payable in quarterly instalments at the inception of each quarter. The final premium to be paid by the Assured shall be 100 times the total incurred losses as hereinafter defined, divided by 65, provided that in no event shall the final premium be less than that developed by the following minimum rate nor greater than that developed by the following maximum rate:

Minimum Rate

$1.20 per $100 of total gross receipts

Maximum Rate

$2.40 per $100 of total gross receipts

The words “total incurred losses” as used herein, shall mean actual paid losses, allocated loss expenses including legal fees and the reserves, as esti mated by the Insurers for unpaid losses, outstanding at the time of adjustment and final re-adjustment.

Adjustment of the premium as provided herein shall be made at each anniversary date.”

The premium so calculated is therefore subject to a minimum rate and a maximum rate and involved the setting up by Lloyd's of a reserve for unpaid liabilities. Relying on their own calculations, Lloyd's claimed the maximum during each year, whereas the plaintiff contested Lloyd's figures, established its own premiums payable in the years in question and entered the amounts in its books as accounts payable, not as a reserve.

As it turned out, the amounts entered in plaintiff's books as"accounts payable" for premiums were inferior to the amounts they ended up by paying Lloyd's for each and every year. After much discussion between the plaintiff and Lloyd's, plaintiff paid close to the maximum payable at the end of each adjustment period.

The secretary-treasurer of the plaintiff company, a chartered accountant, testified that the amounts of premiums payable were based on their judgment as to what the annual adjustments would be. He set the amounts up as accounts payable and expense, not as a reserve, because these were accounts payable, the events had taken place".

Dubé, J., at page 714 (D.T.C. 6437) states:

The accountants did not set aside approximate amounts as "reserve" against contingencies, these amounts were booked as definitely payable because the premiums had been earned, the accidents had occurred, the claims had been filed, the investigations had taken place, the quantum of damage assessed, and the amounts entered.

The Court held that the taxpayer could deduct its premiums.

Mr. Craig, a chartered accountant, on behalf of the appellant testified that a reserve is an appropriation of retained earnings at the discretion of management or required by statute and it is not an amount to cover the known liabilities, so the maximum premium would not be considered a reserve under generally accepted accounting principles, nor could it be considered a contingent account. He referred to section 3290 of the CICA Handbook, paragraphs .02 and .04. It provides that:

.02 A contingency is defined as an existing condition or situation involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. Resolution of the uncertainty may confirm the acquisition of an asset or the reduction of a liability or the loss or impairment of an asset or the incurrence of a liability.

.04 In the preparation of the financial statements of an enterprise, estimates are required for many on-going and recurring activities. However, the mere fact that an estimate is involved does not of itself constitute the type of uncertainty which characterizes a contingency. For example, amounts owed for goods or services received but not billed are not contingencies, even though the amounts may be estimated. There is nothing uncertain about the fact that these obligations have been incurred; any uncertainty is related solely to the amounts thereof.

Counsel for the appellant also submitted that paragraph 18(1)(e) of the Act equally with paragraph 18(1)(a) did not preclude the application of GAAP. I will deal with this later.

In the alternative argument the appellant’s counsel stated that if the maximum premium amount cannot be deducted as an expense, then the amount should be deductible as a policy reserve pursuant to paragraph 20(7)(c) as an amount prescribed in Regulation 1400(e).

Paragraph 20(1)(m) of the Act deals with setting-up of reasonable reserves and subsection 20(7) provides for exceptions to paragraph 20(1)(m) saying that such does not apply in certain circumstances. Therein follows, inter alia, paragraph 20(7)(c) which states:

(c) as a reserve in respect of insurance, except that an insurance corporation may, in computing its income for a taxation year from an insurance business, other than a life insurance business, carried on by it, deduct as policy reserves such amounts as are prescribed for the purposes of this paragraph.

Regulation 1400 of the Act, as in force during the relevant taxation years, provided:

For the purposes of paragraph 20(7)(c) of the Act, an insurance corporation in computing its income for a taxation year may deduct, in respect of . . .

and 1400(e) follows stating:

(e) a policy where an event has occurred before the end of the year that has given or is likely to give rise to a claim under the policy (in this paragraph referred to as ''the liability”), such amount as the corporation may claim not exceeding the lesser of

(i) a reasonable amount in respect of the liability as at the end of the year, and

(ii) the reserve, in respect of the liability, reported by the corporation in its annual report for the year to the relevant authority;

Regulation 1404(2) defines"relevant authority” as follows:

(a) the Superintendent of Insurance for Canada, if the insurer is required by law to report to him, or

(b) in any other case, the Superintendent of Insurance or other similar officer or authority of the province under whose laws the insurer is incorporated.

Regulation 1402 provided:

For the purposes of sections 1400 and 1401, any amount determined under those sections shall be determined on a net of reinsurance ceded basis.

Regulation 1400(e) accommodates the insurance industry's practice of deducting so-called “incurred but not reported" ("IBNR") loss reserves. Mr. Linton, a chartered accountant qualified as an expert in insurance matters, testified that an IBNR reserve includes amounts which the insurer estimates it will have to pay on account of claims arising in the year, and expenses associated with those claims, such as legal fees and other amounts paid to third parties.

In applying Regulations 1400(e) and 1402 to Co-operators, counsel stated it is necessary to look to the commercial reality of its reinsurance agreements. As indicated by the Federal Court of Appeal in Canada v. Placer Dome Inc., [1992] 2 C.T.C. 98, 92 D.T.C. 6402, at pages 109-10 (D.T.C. 6411):

.. it is the substance of a transaction that must be looked at in order to determine the true legal rights and obligations of the parties it is the commercial and practical nature of the transaction, the true legal rights and obligations flowing from it, that must be looked at to determine its tax implications.

Having considered these criteria the appellant's counsel said that it was evident that the appellant's burning cost satisfied each element of Regulation 1400(e) as set-out in that Regulation.

As to the words "in respect of" in Regulation 1400(e) the Court was told that the provision for its reinsurance premium liability is an amount" in respect of" the policies written by Co-operators and "in respect of" claims under these policies. Reference was made to the case of Nowegijick v. The Queen, [1983] 1 S.C.R. 29, [1983] C.T.C. 20, 83 D.T.C. 5041 wherein the Supreme Court of Canada held at page 39 (C.T.C. 25, D.T.C. 5045):

The words “in respect of” are, . . . words 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 was said that Regulation 1402 does not apply to reduce the amount deductible by Co-operators pursuant to Regulation 1400(e). The effect of the reinsurance premium formula is that until excess losses have triggered the maximum premium, in substance, no reinsurance has been ceded. Mr. Wilmot, a witness qualified as an expert in reinsurance industry practice, had given a report in which he indicated:

The reinsurer's assumption of risk . . . only comes in to play if the burning cost exceeds the maximum rate. Only then does the reinsurer assume liabilities that will not be reimbursed through the swing rating mechanism.

Up to the agreed maximum burning cost, Co-operators had not transferred the risk of these excess losses

In conclusion appellant's counsel had indicated that the most significant expense of the appellant was the losses it must pay out. An insurer's loss development can take five to seven years where personal injuries are involved, as was the case in the largest segment of Co-operators' business. Accordingly, extensive reliance must be placed on estimates and statistics. These commercial realities of Co-operators' business are relevant when considering the applicable provisions of the Act in issue. In Johns-Manville Canada Inc. v. The Queen, supra, Estey, J., at page 72 (C.T.C. 126, D.T.C. 5384) endorsed “the application of the common sense approach to the business of the taxpayer in relation to the tax provisions, . . .”. In Canada v. Nowsco Well Service Ltd., supra, at page 424 (D.T.C. 6318) the Federal Court of Appeal advocated "a common sense, realistic and business-like appreciation" by the Court of the taxpayer's circumstances.

Respondent's position

It is interesting to point out at the outset that the Minister does not dispute the deductibility of additional premium that is arrived at by the calculation in accordance with the prescribed formula. In fact, it has allowed additional premium amounts that were calculated in accordance with the formula. What he does dispute is that portion of the maximum premium deducted which was not actually incurred in the years in question. It is the portion between additional premium incurred in accordance with the formula and the maximum premium amount that is in dispute. He objects to the fact that the appellant has attempted to deduct the full amount of the maximum premium on the strength of the expectation that excess claims will eventually result in the maximum premium becoming due and payable.

The basic argument of the respondent comes within the provisions of paragraphs 18(1)(a), 18(1)(e) and Regulations 1400(e) and 1402 of the Act.

As to the paragraph 18(1)(a) argument counsel pointed out that recent cases have fairly consistently held that contingent liabilities are not deductible by this paragraph. Reference is then made to three legal principles.

The first is that there must be an obligation to pay money. In support of this, the Court was referred to the case of The Queen v. Burnco Industries Ltd., [1984] C.T.C. 337, 84 D.T.C. 6348. There the Federal Court of Appeal made the distinction between an obligation under a contract, a legal obligation under a contract, and the costs of fulfilling that obligation, all in the same year.

The second principle is that there must be a clearly legal obligation to pay the sum of money in the year. Reference here was made to the case of Newfoundland Light & Power Co. v. Canada, supra. There Pratte, J., in the Federal Court of Appeal said at page 239 (D.T.C. 6173):

Indeed, in order for an expense to be incurred during a year, the obligation to pay must be created during that year; similarly, there is no cost of property to a taxpayer as long as the obligation to pay that cost has not come into existence.

Also referred to was the case of Northern & Central Gas Corp. v. The Queen, [1985] 1 C.T.C. 192, 85 D.T.C. 5144 (F.C.T.D.) [aff'd [1987] 2 C.T.C. 241, 87 D.T.C. 5439 (F.C.A.)]. There is found in a judgment of Reed, J., at pages 200-201 (D.T.C. 5149-50) the following:

The problem the taxpayer has to meet is that while the amount it expected to pay was definitely ascertainable there was no existing legal obligation at the end of 1977 requiring payment. The decision in Meteor Homes Ltd. v. MNR, [1960] C.T.C. 419 at 429, 61 D.T.C. 1001 (Ex Ct) quoted at page 1429 (D.T.C. 1007-8) with approval the following:

“All the above cases serve to illustrate the principle that, in the case of a taxpayer on an accrual basis, where an expense is incurred and the amount is definitely ascertainable and legally liable or payable in the year . . . such amount may be claimed as an expense of the year.

Further at page 201 (D.T.C. 5150) there is found:

There is no doubt that an accountant would deem it necessary to reflect this fact in the books of the company but it cannot be said to be an expense for tax purposes. It was a reserve for a contingent liability. The fact that the amount of the liability was ascertainable and that the probability of it not becoming payable was very small (almost infinitesimally small) does not affect the nature of the liability (refer: Guay case, supra). There was no legal liability on the plaintiff at the end of 1977 to “refund” the sum to its customers.

While Reed, J. was applying paragraph 18(1)(e) of the Act counsel for the respondent in the present case submitted these principles applied with even greater force to the provisions of paragraph 18(1)(a).

Moving on to the third legal principle it was indicated that the sum of money involved must be ascertained in the year or is ascertainable in the year. Reference was made in support of this to the Newfoundland Light & Power Co. case, supra, and also to J.L. Guay Ltée v. M.N.R., [1971] C.T.C. 686, 71 D.T.C. 5423 [aff'd [1973] C.T.C. 506, 73 D.T.C. 5373 (F.C.A.); aff'd [1975] C.T.C. 97, 75 D.T.C. 5094 (S.C.C.)]. There at page 692 (D.T.C. 5427) we find:

In most tax cases only amounts which can be exactly determined are accepted. This means that, ordinarily, provisional amounts or estimates are rejected, and it is not recommended that data which is conditional, contingent or uncertain be used in calculating taxable profits. If, indeed, provisional amounts or estimates are to be accepted, they must be certain.

From documents submitted by the appellant, counsel for the respondent was able to show the Court some examples. In the treaty year 1984 as at the end of that year there were no incurred excess claims and no balance due to the reinsurers. In 1982 the maximum premium only became payable by the end of 1985 and yet the appellant wanted to deduct the full amount in 1982.

The Canadian and British Insurance Companies Act was referred to and none of its provisions showed that the Department of Insurance was concerned with reassuring profit for a one-year period and collecting tax.

In the years in question, the Minister concedes that Co-operators, insofar as the reinsurance accounting was concerned, accounted in accordance with generally accepted accounting principles, but GAAP does not resolve a legal tax issue.

Reference to paragraph 18(1)(e) of the Act was very brief. Support that this paragraph has no application to the present case in view of the restrictions imposed under paragraph 18(1)(a) cases comes from the recent decision in Nomad Sand & Gravel Ltd. v. Canada, [1991] 1 C.T.C. 60, 91 D.T.C. 5032 (F.C.A.).

In the present case Co-operators set up a separate account to hold and record the burning cost (account #291). The maximum premium amount was transferred or credited to this contingent account. The account was set up in this way and not as a payable amount because amounts in the account were not considered liabilities but contingencies.

Regulation 1400(e) and paragraph 20(7)(c) of the Act were spoken to by counsel and concluded that in conjunction with the Canadian and British Insurance Companies Act everything has to relate to the policy between Cooperators and its own insured. The liability must arise out of this. The cost of reinsurance relates to a separate contract and counsel said such is outside the scope of the words of Regulation 1400(e). Re Northern Union Insurance Co. (1984), 33 Man. R. (2d) 81, a Manitoba Queen's Bench judgment in 1984 confirmed this position as to a separate contract between the insurer and the reinsurer. This also was expressed by Mr. Wilmot, one of the appellant's witnesses.

Final argument of the respondent dealt primarily with Regulation 1402 of the Act and its relation to Regulation 1400 and subsection 20(7) of the Act. An explanation of the words" net of reinsurance basis” was given showing such to be all payment obligations of a reinsurer under a reinsurance treaty.

In conclusion the respondent mentioned that in each of the taxation years involved the sums paid and claimed as deductions were not outlays within the meaning of paragraph 18(1)(a) of the Act and were therefore not deductible in computing income from the business in each of the relevant years.

The sums involved were transferred or credited to a reserve or contingent account (account #291) and pursuant to paragraph 18(1)(e) were not deductible in computing each year's income. Nor were the sums deductible as policy reserves under paragraph 20(7)(c) as such were not prescribed in Regulation 1400 nor amounts within the meaning of Regulation 1400(e). Also such sums could never be fully deductible as they included loading factors.

The amount claimed as a deduction pursuant to Regulation 1400(e) was properly reduced by the reinsurance as stipulated in the relevant treaty, in accordance with Regulation 1402.

Analysis

While all arguments by all counsel for both the appellant and respondent were thorough and quite lengthy only the salient parts will be referred to below.

There were two principal arguments by the appellant:

(1) the maximum premium payable is not a contingency but a liability;

(2) in the alternative the maximum premium is an amount that should be allowed under paragraph 20(7)(c) of the Act as prescribed in Regulation 1400(e).

After setting out several cases, which will be dealt with below, counsel for the appellant quoted from the case of West Kootenay Power & Light Co., supra, which said that the matching principle will represent the truest picture of income.

It should be pointed out that the West Kootenay Power & Light Co. case does not apply to these appeals; that case dealt with the proper inclusion of earned but unbilled amounts and not the deductibility of expenses. It was a subsection 9(1) case not a section 18 case. Moreover, insofar as the above cited cases deal with the importance of the commercial realities of a particular industry, it is my view that these cases are not of particular help to the appellant inasmuch as every case must be dealt with on its own facts and the facts of each case are crucial to its outcome.

What is an expense incurred within the meaning of paragraph 18(1)(a) is a question of law. What are generally accepted accounting principles is a starting point and is not determinative of the issue. The mere fact that financial statements were prepared on the basis of accounting practices prescribed or permitted by the Department of Insurance, adds nothing to the legal issue.

In order for there to be an expense incurred under paragraph 18(1)(a), first, there must be a presently subsisting legal obligation to pay a sum of money in the year. If not, then the amount is a contingent liability. In The Queen v. Burnco Industries Ltd., supra, Pratte, J., held at page 337 (D.T.C. 6348-49) that:

an expense, within the meaning of paragraph 18(1)(a) of the Income Tax Act, is an obligation to pay a sum of money. An expense cannot be said to be incurred by a taxpayer who is under no obligation to pay money to anyone . . an obligation to do something which may in the future entail the necessity of paying money is not an expense.

A second requirement is that the legal obligation to pay has arisen in the year. In Newfoundland Light & Power Co. v. Canada, supra, at page 239 (D.T.C. 6173) Pratte, J., states:

Indeed, in order for an expense to be incurred during a year, the obligation to pay must be created during that year; similarly, there is no cost of property to a taxpayer as long as the obligation to pay that cost has not come into existence.

Moreover, Mr. Justice Pratte rejected the proposition that, in accordance with generally accepted accounting principles, an expense can be incurred for the purpose of the Act even though a legal obligation to pay did not exist in the year. At page 239 (D.T.C. 6173) he stated:

At the hearing, the appellant’s main submission was that Mr. Justice Martin, instead of viewing the problem in a purely legalistic way, as had been done in Guay and Colford, should have adopted a more realistic approach and, following the decision of the Supreme Court of Canada in Time Motors Ltd. v. M.N.R., decided the case in the light of the generally accepted accounting principles which apparently teach that an expense or cost may have been incurred even though the legal obligation to pay that expense or cost does not yet exist. This argument must, in my view, be rejected. The Time Motors decision is not relevant. The Court held, in that case, that the obligation of the taxpayer under certain credit notes was ~ subsisting until satisfied or expired". It reached that conclusion without the help of accounting principles. It made reference to those principles for the sole purpose of determining the meaning to be given to the expression "contingent account" in paragraph 18(1)(e) of the Act, a provision which has no application here.

Reference was made that the present appeals were similar to those in Day & Ross Ltd. v. The Queen, supra. In my opinion, Day & Ross is distinguishable on its facts because in that case the taxpayer's liability for premiums was calculated in accordance with the formula they had agreed to. The taxpayer did not attempt to deduct as an expense more than he would have been allowed in accordance with their formula. Indeed, it seems as if they were more cautious as to their liability than their Insurer who thought that the taxpayer was underestimating its premium liability.

In the case of Co-operators there is no argument that additional reinsurance premiums above the minimum premiums were required for each year to be paid if the annual calculation showed excess claims above each aggregate deductible. This is entirely dependent on the contractual arrangement between the appellant and its various reinsurers. The mere fact that an accident has occurred is irrelevant. That was not the basis for triggering any additional premium. The fact that the accident has occurred creates no certainty as to the obligation to pay the maximum premium.

Finally with paragraph 18(1)(a), the amount payable must be ascertainable in the year. In the appeals at hand, whether the maximum premium would be payable in the year was certainly not ascertainable. What was ascertainable, however, were additional premiums depending on annual calculations or adjustments as to the estimated excess of loss claims.

The appellant failed to show that it was legally bound to pay the maximum premium in the years concerned to the reinsurer and that obligation was not dependent upon future events. The fact that the amount of the liability would eventually be ascertainable and that the probability of having to pay the maximum premium may arise does not, in my view, make the maximum premium a legal liability in the years it was deducted.

It is quite proper to say that liability does not necessarily mean legal liability. In these appeals all depends on the contractual obligation between the appellant and its reinsurers with respect to the payment of the maximum premium.

The Minister argued that if paragraph 18(1)(a) does not disallow the maximum premium paragraph 18(1)(e) would. In light of the foregoing analysis, I will be brief as to the applicability of 18(1)(e).

In the years under appeal, paragraph 18(1)(e) read as follows:

In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(e) an amount transferred or credited to a reserve, contingent account or sinking fund except as expressly permitted by this Part.

The Supreme Court of Canada established in Time Motors Ltd. v. M.N.R., supra, that this paragraph must be construed by reference to accounting practice. Pigeon, J., held at page 506 (C.T.C. 192-93, D.T.C. 5151):

The wording of that provision clearly refers to accounting practice. The only expression applicable to the present case is not "contingent liability” but "contingent account”. This means that the provision is to be construed by reference to proper accounting practice in a business of the kind with which one is concerned. In the present case, the only evidence of accounting practice is that of appellant's auditor, a chartered accountant. His testimony shows that in appellant’s accounts credit notes are treated according to standard practice as current liabilities until they are redeemed or expired. They are not classed as contingent liabilities.

And at page 506 (C.T.C. 193, D.T.C. 5152):

With respect, Gibson, J. was in error in holding that whether or not appellant's financial statements were drawn up according to generally accepted accounting principles could be disregarded. On the contrary, the wording of the relevant provision of the Income Tax Act implies that this is the essential question.

With reference to Mr. Craig's evidence I believe that Mr. Craig, a chartered accountant, may have misunderstood the basic premise of the reinsurance contract, namely, that it is when excess claims exceed the aggregate deductible for the year that additional premiums become payable in accordance with the prescribed formula. In my opinion, according to generally accepted accounting principles as expressed by the above paragraphs .02 and .04 of section 3290 of the CICA Handbook, account #291 was in its substance a contingent account, insofar as there was uncertainty as to whether there would be legal liability to pay the maximum premium. The appellant has attached to the maximum premium the title of liability, but that in itself is not conclusive: No. 297 v. M.N.R. (1955), 14 Tax A.B.C. 100, 55 D.T.C. 611 (T.A.B.). The fundamental difference with contingent amounts that should be accrued and the contingent amount here is that one is accruing on a day-to-day basis and the other is not. The additional premium amount does not accrue on a day-to-day basis; the cost of reinsurance is not based on the passage of time but on the loss experience of the insurer which is an ongoing process. It is noteworthy that this account did not hold moneys used by Co-operators to discharge its minimum premium liability.

In my opinion, the correct interpretation of the meaning of the policy in respect of which a deduction may be taken pursuant to paragraph 20(7)(c) of the Act is a policy between an insurer and its insured. In these appeals, a policy reserve would include estimates of its unpaid claims liability as represented by "provision for unpaid claims”, but not the maximum premium. Indeed, the appellant did not include the maximum premium amount in the reserve for unpaid policy claims. On the balance sheets, the maximum premium liability was shown as either “accounts payable and accrued charges” or “due to reinsurer". Mr. Linton testified that this was done in accordance with industry standard practice. It is only liability arising out of the policy contract with its insured that should be considered, not any liability arising out of a reinsurance contract. There is nothing in the policy contract that requires that the insurer enter into a reinsurance contract. The insurer does so for its own benefit and protection. The cost of reinsurance relates to a separate contract. It creates no privity between the original insured and the reinsurer. This leads me to conclude that any liability arising out of a reinsurance contract by an insurer falls outside the scope of the words of Regulation 1400(e). Regulation 1400(e) does not contemplate all the liability arising out of what is a voluntary and private contract between the insurer and its reinsurers.

In the case of Maritime Telegraph & Telephone Co. v. Canada, supra, there is a passage of great importance in relation to a taxpayer's profit and the Act. This is a recent decision in 1991 wherein Reed, J., said at page 31 (D.T.C. 5040):

It is well settled in the jurisprudence that the computation of a taxpayer's profit for the year is to be determined in accordance with ordinary commercial principles and practices. In addition, the method of accounting for tax purposes should be that which best reflects the taxpayer's true income position for the year unless the Income Tax Act dictates otherwise.

The opposing arguments seem to follow these lines. The appellant saying that proper commercial principles and practices were adopted while the respondent has maintained that the Act dictates otherwise.

Conclusion

The maximum premium does not meet the requirements of an "expense incurred” as delineated in the case law interpreting paragraph 18(1)(a) of the Act. According to the premium formula, there was no obligation to pay the maximum premium in each treaty year if the obligation did not arise in the year, nor was the maximum premium a liability likely to be ascertainable in the year.

Furthermore, in my opinion, generally accepted accounting principles would consider account #291 to be a "contingent account" within the meaning of paragraph 18(1)(e) based on its accounting treatment.

Liability for reinsurance premium was not an amount contemplated in Regulation 1400(e).

There is no question that if in future years to those under appeal the necessity to pay amounts up to the maximum premiums arise then Cooperators will be entitled to a deduction. To allow otherwise would give the appellant a tax advantage and would presumably be earning income on the amounts in account #291. As Mr. Craig in his evidence indicated, a subsequent adjustment to an assessment is not an error.

The Minister has properly reassessed the appellant in respect of the years under appeal. It has properly allowed the deduction of additional premium to the extent that there were claims in excess of the aggregate deductible. And, it has properly disallowed any additional premium amounts taken as a deduction on the strength of an estimate or expected liability, even if for the 1979, 1980 and 1981 treaty years, the maximum premium ended up being paid in the years that followed the particular treaty year.

The appeals are hereby dismissed.

Appeals dismissed.