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Citation: 2006TCC551
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Date: 20061013
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Dockets: 2003-2245(IT)G
2003-2883(IT)G
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BETWEEN:
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THE NATIONAL LIFE ASSURANCE
COMPANY OF CANADA,
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Appellant,
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and
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HER MAJESTY THE QUEEN,
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Respondent.
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REASONS FOR JUDGMENT
Hershfield J.
[1] The Appellant carries on business as a life insurer in Canada and at all relevant times issued life insurance and annuity contracts including segregated fund policies.
[2] The subject appeals concern the Appellant's claim in respect of its 1997 and 1998 taxation years, for a reserve under subparagraph 138(3)(a)(i) of the Income Tax Act (Canada) (the "Act").
[3] That subparagraph allows reserves for life insurance policies as claimed subject to a maximum allowed by regulation. It reads as follows:
138(3) In computing a life insurer's income for a taxation year from carrying on its life insurance business in Canada, there may be deducted
(a) such of the following amounts as are applicable:
(i) any amount that the insurer claims as a policy reserve for the year in respect of its life insurance policies, not exceeding the total of amounts that the insurer is allowed by regulation to deduct in respect of the policies.
[4] The Minister determined that the amount claimed by the Appellant as a policy reserve in respect of each of the subject years exceeded the amount allowed by regulation.
[5] An Agreed Statement of Facts was filed prior to the hearing. While I will refer to particular agreed facts from time-to-time in these Reasons, I note at the outset that it is agreed that the reserves that are the subject of these appeals are in respect of life insurance policies in Canada that are post-1995 life insurance policies. The relevant regulation in respect of such policies is contained in section 1404 of the Regulations to the Act. Subsection 1404(1) of such regulations reads as follows:
1404(1) For the purpose of subparagraph 138(3)(a)(i) of the Act, there may be deducted, in computing a life insurer's income from carrying on its life insurance business in Canada for a taxation year in respect of its life insurance policies in Canada that are post-1995 life insurance policies, the amount the insurer claims, not exceeding
(a) the amount determined under subsection (3) in respect of the insurer for the year, where that amount is greater than nil, and
(b) nil, in any other case.
[6] Subsection 1404(3) of the Regulations sets out a formula for calculating the maximum reserve amount (the maximum tax actuarial reserve or "MTAR"[1]) that a life insurer may claim for the purposes of subsection 1404(1). While the formula requires the calculation of several amounts, the parties acknowledged that it was only the calculation of the "A" amount referred to in the formula that was relevant for the purposes of these appeals. The calculation in dispute then is framed by that part of subsection 1404(3) of the Regulations that reads as follows:
(3) For the purposes of paragraphs (1)(a) and (2)(a), the amount determined under this subsection in respect of an insurer for a taxation year, in respect of its life insurance policies in Canada that are post-1995 life insurance policies, is the amount, which may be positive or negative, determined by the formula
A + B + C + D − M
where
A is the amount (except to the extent the amount is determined in respect of a claim, premium, dividend or refund in respect of which an amount is included in determining the value of B, C or D), in respect of the insurer's life insurance policies in Canada that are post-1995 life insurance policies, equal to the lesser of
(a) the total of the reported reserves of the insurer at the end of the year in respect of those policies, and
(b) the total of the policy liabilities of the insurer at the end of the year in respect of those policies.
[7] In brief then the reserve (MTAR) calculation in dispute concerns the determination of the lesser of reported reserves and policy liabilities. Each of these highlighted terms is defined in section 1408 of the Regulations as follows:
"policy liability" of an insurer at the end of the taxation year in respect of an insurance policy or a claim, possible claim or risk under an insurance policy means the positive or negative amount of the insurers reserve in respect of its potential liability in respect of the policy, claim, possible claim or risk at the end of the year determined in accordance with accepted actuarial practice, but without reference to projected income and capital taxes (other than the tax payable under Part XII.3 of the Act).
"reported reserve" of an insurer at the end of a taxation year in respect of an insurance policy or a claim, possible claim, risk, dividend, premium, refund of premiums or refund of premium deposits under an insurance policy means the amount equal to
(a) where the insurer is required to file an annual report with its relevant authority for a period ending coincidentally with the year, the positive or negative amount of the reserve that would be reported in that report in respect of the insurer's potential liability under the policy if the reserve were determined without reference to projected income and capital taxes (other than the tax payable under Part XII.3 of the Act);
(b) where the insurer is, throughout the year, subject to the supervision of its relevant authority and paragraph (a) does not apply, the positive or negative amount of the reserve that would be reported in its financial statements for the year in respect of the insurer's potential liability under the policy if
(i) those statements were prepared in accordance with generally accepted accounting principles, and
(ii) the reserve were determined without reference to projected income and capital taxes (other than the tax payable under Part XII.3 of the Act).
[8] One reserve calculation (policy liabilities) then appears to rest on calculations in accordance with generally accepted actuarial practice while the other (reported reserves) appears to rest on calculations reported to the Appellant's relevant authority, which in this case is the Superintendent of Financial Institutions.
[9] In the case at bar, as acknowledged in the Agreed Statement of Facts, the reported reserves and policy liabilities were equal amounts. Similarly it is agreed, in respect of the calculation of the reported reserves, that even though the Appellant was required to and did report to the Superintendent of Financial Institutions and thereby had its reported reserves governed paragraph (a) of the definition of reported reserves, the calculation if made under paragraph (b) of that definition (namely in accordance with general accepted accounting principles ("GAAP")) would give rise to the same reported reserve amount.[2]
[10] There is no dispute as to the amount of the reported reserves or policy liabilities which are the starting points for the MTAR calculations that are in dispute (i.e. the calculation of the "A" amount in subsection 1404(3)). From there paragraph 1406(b) of the Regulations modifies that calculation in respect of segregated fund policies. The Appellant asserts that paragraph 1406(b) increases the MTAR in respect of its segregated fund policies so as to increase its deductible amount under subsection 138(3). The Respondent asserts that it does not. The issue then is to determine the impact, if any, paragraph 1406(b) has on the Appellant's MTAR having regard to its segregated funds.
[11] A segregated fund is recognized and defined in subsection 138.1(1) of the Act as follows[3]:
138.1(1) In respect of life insurance policies for which all or any part of an insurer's reserves vary in amount depending on the fair market value of a specified group of properties (in this section referred to as a "segregated fund"), for the purposes of this Part, the following rules apply ...
[12] The reported reserves and policy liabilities are calculated on a policy by policy basis. The policies for which a segregated fund was maintained in the subject years have been identified and agreed upon.
[13] In determining the MTAR in subsection 1404(3), paragraph 1406(b) provides as follows:
1406. Any amount determined under section 1404 or 1405 shall be determined
. . .
(b) without reference to any liability in respect of a segregated fund (other than a liability in respect of a guarantee in respect of a segregated fund policy). (emphasis added)
[14] In the context of the present appeals then it is necessary to revisit the MTAR calculations that are in dispute (i.e. the calculation of the "A" amount in subsection 1404(3)) and redo the reported reserve and policy liability calculations according to this direction. In order to redo such calculations without reference to any liabilities in respect of segregated funds it is necessary to examine the formulistic actuarial calculations that include them. These formulistic actuarial calculations are not only wholly external to the Act and Regulations but are conceived and designed to measure the solvency of an insurer in terms of its ability to pay out policyholders. Reports to the Superintendent of Financial Institutions are reports of asset values (including projected earnings) available to meet liabilities (including projected liabilities - most particularly actuarial liabilities to pay death benefits and other guaranteed amounts such as amounts guaranteed in the case of segregated funds). While such formulae designed for such purpose do not have an obvious connection to a reserve for income tax purposes, they have nonetheless necessarily been incorporated into the calculation of tax reserves for insurance companies.
[15] The parties acknowledge this and agree that the external actuarial reserve calculations need to be examined in light of paragraph 1406(b). Indeed the parties have set out those external provisions which form the basis for calculating reported reserves and actuarial liabilities in respect of the Appellant's segregated funds on the basis that paragraph 1406(b) cannot be applied except in the context of those external provisions.
[16] To better understand those external provisions and the arguments of the parties, further background is required.
Background
[17] The Appellant was governed at all relevant times by the Insurance Companies Act (Canada) and was required by law to report to the Superintendent of Financial Institutions.
[18] In the case of traditional life insurance policies the life insurer invests the premiums it receives from its life insurance policyholders in assets in a pool known as the "general fund". This fund is resorted to for the purpose of paying the benefits specified in such life insurance policies. Under a segregated fund policy the policyholder pays the insurer a sum of money and directs the insurer to invest all or a portion of it in one or more distinct, segregated pools of assets held by the insurer. Each segregated pool of assets is referred to as a "segregated fund". The Appellant has several segregated funds all maintained separately and held outside of the general fund. Each segregated fund has its own investment criterion and objectives. The investment risk flows through to the policyholder which is different from general fund contracts although the segregated fund contracts I am dealing with provide for minimum guarantee benefits on death or maturity. If necessary then, the insurer would access the general fund to pay such guarantees should the policyholder's interest in a particular segregated fund not have sufficient value in relation to the guaranteed benefit.
[19] The Appellant, not the policyholders, own the assets in the segregated funds. Policyholders have a unitized beneficial interest in the value of the assets in the particular segregated fund in which the policyholder has directed monies.[4] The Appellant administers the segregated funds and manages the investments held by it in each such segregated fund. It incurs expenses relating to such management.
[20] The value of the assets in the segregated fund are affected by: monies directed by policyholders to be invested in the particular segregated fund;[5] investment returns on assets in the segregated fund; deductions for administrative charges and investment management fees; and, deductions for death benefits, maturity benefits and withdrawals requested by policyholders.
[21] As part of its requirement to report to the Superintendent of Financial Institutions, the Appellant was required to report it liabilities and assets to the Superintendent annually on a form referred to as OSFI 54. Such form includes the Appellant's liabilities for its policies that have variable investment options ("UltraFlex Policies"). As will be noted momentarily it is these policies that have a segregated fund component.
[22] The Appellant was also required to file with the Superintendent a form known as OSFI 85 in which it was required to provide further information of the total assets and total liabilities in respect of the segregated funds. This report sets out more particularly the components and subcomponents for the calculation of segregated fund liabilities.
[23] The Appellant was also required to file with the Superintendent a report of the appointed actuary. The Report of the Appointed Actuary also contains the breakdown of the Appellant's segregated fund liabilities. This report sets the components and subcomponents for the calculation of segregated fund liabilities on the same basis as done in Form OSFI 85.
[24] All the reports filed by the Appellant with the Superintendent in respect of the subject years were accepted by him without requiring modification.
[25] As to identifying segregated fund liabilities it is necessary to point out that there are two components to the UltraFlex Policies. The first component is referred to as the fixed component. This component consists of fixed term investments similar to guaranteed investment certificates. This component is held by the Appellant in its general fund. The second component is referred to as the variable component. The variable component consists of other securities the value of which varies in the market place. This component is accounted for by the Appellant outside its general fund. It is the variable component of the UltraFlex Policies that are accounted for in segregated funds.
[26] In calculating policy liabilities and reported reserves, the variable component of the UltraFlex Policies must be separately valued to determine the actuarial reserve attributable to them. In this regard it is agreed that the Appellant was required to calculate all its policy reserves by using the policy premium method ("PPM") for each of its UltraFlex Policies in accordance with generally accepted actuarial practice prescribed by the Canadian Insurance Association ("CIA").[6] The PPM requires taking into account actuarial estimates of future positive and negative cash flows arising from the policy. Accordingly, looking at the reserve for the variable component of the UltraFlex Policies, the actuarial report looks to the following three components (subcomponents of the variable component of segregated fund policies):
(i) segregated fund account balances in respect of the policies;
(ii) the present value of future commissions, investment expenses and administrative expenses less the present value of future management fees and surrender charges in respect of the segregated funds; and
(iii) the present value of liabilities in respect of the minimum death and maturity benefit guarantees in respect of the segregated funds.
[27] These three subcomponents are the external provisions (external to the Act and Regulations) at which paragraph 1406(b) is directed. Both parties approached the appeals on this basis. The arithmetic total of these three subcomponents determine the reported reserves and actuarial liabilities in respect of the Appellant's segregated funds.[7]
[28] It is the amount calculated under (ii) of the above formula that is the subject of the appeals (the "subcomponent (ii) amount"). Since its arithmetic orientation is to calculate a liability for which there must be a reserve, it looks at the liability net of related receipts. Given this orientation and given that related receipts are budgeted to exceed anticipated expenses, as would be expected in a for-profit business, the subcomponent (ii) amount is expected to be, and it seems to me would invariably be, a negative number. In any event in the case at bar at least the subcomponent (ii) amount was negative and has a label: "the negative reserve amount". The negative reserve amount for segregated funds reduces actuarial liabilities and reported reserves. About that there is no dispute.[8]
[29] The revenues and expenses included in the calculation of the subcomponent (ii) amount are accounted for as part of the general fund. That is, administrative profits and losses in respect of the segregated funds (i.e. both positive and negative amounts calculated under subcomponent (ii) in respect of segregated funds), end up as assets or liabilities of the general fund. However that is not to say that same have not been determined in respect of the segregated fund policies. Clearly they have been.
[30] The Appellant calculated the amount of the maximum reserve deductible under subparagraph 138(3)(a)(i), its MTAR, pursuant to the formula in subsection 1404(3) of the Regulations excluding the subcomponent (i) and (ii) amounts in calculating the "A" amount in respect of its segregated funds. The exclusion was made pursuant to paragraph 1406(b) of the Regulations on the basis it required that the MTAR amount determined under section 1404 be determined "without reference to any liability in respect of a segregated fund (other than a liability in respect of a guarantee in respect of a segregated fund)".
[31] The Minister reassessed the Appellant on the basis that the subcomponent (ii) amount was a negative amount and was not as such a "liability" and, therefore, it did not meet the requirement for exemption under paragraph 1406(b). This reduced the Appellant's MTAR by $7,922,000.00 in 1997 and $15,770,000.00 in 1998 and increased the Appellant's taxable income in each of those years by those amounts.
[32] As further background, I note that the segregated funds are trusts for tax purposes. The Appellant has to file T-3 returns for each of its segregated funds and issues T-3 slips to the policyholders reflecting their interest in each of the funds and the distributions of income for each year. The Appellant's T-3 returns show the Appellant's taxable income, the amount and breakdown of the type of income that is distributed to the beneficiaries and what is retained in the fund subject to tax. The fixed, GIC type investment, component of the UltraFlex Policies are not in segregated funds.
[33] The negative reserve amounts which form part of the earnings of the general fund are not included in the earnings of the segregated funds.[9]
[34] While the segregated funds are trusts for income tax purposes, they are just a separate account for statutory purposes under insurance law. It is only in that context that separate accounts are maintained to record the deposits and earnings of the segregated fund policyholders. One cannot issue a segregated fund contract out of a segregated fund because a segregated fund does not exist for legal purposes. Insurers issue general fund annuity contracts (including segregated fund policies) which are considered to be insurance policies. The UltraFlex polices have a guarantee which applies on death or withdrawal and thereby have an actuarial component. The guarantees bring the policies under the Insurance Act as annuity contracts and as such are not subject to the Regulations of the security commissions of provinces. The guarantee is funded out of the general fund but the liability under the guarantee arises only to the extent that the asset value in a segregated fund payable to a policyholder is less than the guaranteed amount payable to that policyholder. Such amount is a subcomponent of the actuarial liability in respect of a segregated fund (namely subcomponent (iii)) and it is not taken out of the reserve for income tax purposes under paragraph 1406(b).
Issue Re-stated and Positions of the Parties
[35] With that background the issue is a narrow one: whether the subcomponent (ii) amount, as a negative liability amount, must be excluded pursuant paragraph 1406(b) from the calculation of the "A" amount in the calculation of the MTAR under subsection 1404(3). As noted, the parties agree, and it seems apparent to me as well, that it is the calculation of the subcomponent (i), (ii) and (iii) amounts at which 1406(b) is specifically aimed. Subcomponent (i) is a liability to UltraFlex policyholders and is excluded from the calculation of reserves for tax purposes. Subcomponent (iii), which relates to segregated fund policy guarantees, is also a liability to UltraFlex policyholders and would be excluded as such under 1406(b) but for the express language that says not to exclude guarantees.
[36] The Respondent argues that just because the subcomponent (i) and (iii) amounts are liabilities and the total of the three subcomponents of the actuarial formula at which paragraph 1406(b) is directed intends to and does calculate a liability in respect of segregated funds does not mean that the subcomponent (ii) amount is a liability as well. That it is a component part of a calculation of a liability does not make it a liability if it is not itself a liability in the ordinary sense of the word. The excess of the present value of revenues (administrative fees and surrender charges) earned in the administration of segregated funds over the present value of expenses incurred administering those funds is not a liability of the Appellant to anybody.
[37] The Appellant on the other hand sees the reference to liabilities in 1406(b) simply as a reference to an "amount" that is, as an agreed fact, a part of its liability attributable to and calculated in respect of its UltraFlex Policies which can be positive or negative but in either case, as a part of its liability, it must be excluded under 1406(b).
[38] The following is a summary of the arguments made at the hearing.
Appellant's Arguments
[39] The Appellant asserts that it has made a prima facie case contrary to the premise upon which the Respondent reassessed the Appellant, namely the premise or assumption that the reserve amount in subcomponent (ii) was not a liability and therefore did not meet the requirements for exclusion in the calculation of the MTAR.
[40] The UltraFlex Policies in question create an obligation to make future payments. This is a potential liability calculated to ensure the reserves are sufficient to pay those liabilities as they fall due. This is agreed as is the fact that this actuarial liability in respect of segregated funds includes the subcomponent (ii) amount as required by the PPM imposed on insurers maintaining segregated funds.
[41] As a required component of the Appellant's actuarial liability in respect of policyholders with segregated fund investments, it is a liability in respect of segregated funds. The Appellant thereby encourages a construction of paragraph 1406(b) that recognizes that it was constructed to hive out all components of the actuarial calculation of policy liabilities in respect of segregated funds except the subcomponent (iii) amount.
[42] This is the Appellant's principle argument. Other embellishments of it or ways to express it come down to the same point which is that the negative reserve amount does not lose its character as being an actuarial liability simply because the revenue component of the subcomponent (ii) amount exceeds the expense component. The characterization of the subcomponent (ii) amount does not depend on it being positive or negative. Giving the word "liability" a meaning not consistent with its ordinary meaning is, in effect, contextually required.
[43] The Appellant argues that it is irrelevant that the general fund accounts for both the subcomponent (ii) and (iii) amounts. They are nonetheless amounts determined only with respect to segregated funds as contemplated in paragraph 1406(b). The words "in respect of" are words of the widest possible scope.[10] If the Appellant did not have segregated fund policies it would not have a subcomponent (ii) amount included in its actuarial liability or policy reserve.
[44] The Appellant points out that it is not relevant that the liability component of the subcomponent (ii) amount is a liability to third parties (as opposed to being a liability to policyholders). This is underlined by the view that if the subcomponent (ii) amount was positive it would be a liability in every sense of the word expressly excluded by paragraph 1406(b). PPM requires this third-party liability inclusion as a component of actuarial liabilities in respect of segregated funds.
[45] Further, it is argued that the Regulations clearly state that a negative amount can be a liability. The definition of both "reported reserves" and "policy liabilities", the calculation of the MTAR and Regulation 1407 all require a finding that a negative amount can be a liability for the purposes of paragraph 1406(b) or alternatively require a finding that the fact that the subcomponent (ii) amount is a negative number is irrelevant in determining whether it is a liability.
[46] The Appellant also raises a question as to where the subcomponent (ii) amount fits if it is not a liability. The argument suggests that 1406(b) must be seen as dealing with all components of the PPM and since the subcomponent (ii) amount is not expressly excluded from the exclusion, it must be included as an excluded amount. This argument might be further bolstered by recasting it. If the subcomponent (ii) amount is not a liability - it is not an amount that would properly be included in MTAR in the first place. Recourse to the exclusion in 1406(b) is therefore not necessary. The subcomponent (ii) amount would only be excluded under 1406(b) if it were a positive or real liability because then, as a real liability, it would have been included in the first place.
[47] The Appellant also puts forward one alternative argument, namely, that 1406(b) requires that the MTAR be calculated "without reference" to any liability in respect of a segregated fund. It is asserted that MTAR itself is concerned only with liabilities. It is asserted that the negative reserve amount can only be determined "with reference" to the Appellant's liabilities in respect of segregated funds. This it seems must refer to the fact that the negative reserve amount cannot be computed without reference to liabilities of the Appellant to third parties (i.e. not to policyholders which are the liabilities referred to in subcomponents (i) and (ii)). Put another way, adopting the ordinary meaning of the word "liability" the negative reserve amount can then only be calculated with reference to liabilities in respect of segregated funds. Therefore, in order for MTAR to be determined without reference to such liabilities the negative reserve amount must be excluded from MTAR.
Respondent's Arguments
[48] At the end of the day, the Respondent wants to ensure that the language in the Act and Regulations be interpreted to give effect to a principled reserve for tax purposes consistent with the reporting format used in the insurance industry.
[49] The end result of the actuarial reserve calculations recognizes future profits as part of the Appellant's current financial status. If the insurer takes into account a future profit from the management of funds (and the Appellant did with respect to its UltraFlex Policies), this will, in keeping with generally accepted actuarial practice, have the affect of increasing its reported surplus available to policyholders and thus enhance its liquidity and capacity to carry on business. It is the appropriate business format from which the Appellant cannot resile when computing its income for income tax purposes.
[50] The suggestion is that the insurance industry by its nature looks to the future in the presentation of financial statements. They are irregular in that they seek to estimate both the amount of money needed to pay future claims and other expenses and the expected income amounts from all sources including future premiums, investment income and fund management income. Since accounting concepts differ in respect of insurance companies, the Respondent argues that income tax consequences should follow a parallel course and that the Act and Regulations must be read to give effect to this result. That is, paragraph 1406(b) must be given a construction that would not permit the Appellant to inflate its reserves for tax purposes as it did by departing from the insurance reporting format in calculating its income for tax purposes.
[51] To support their construction of the subject provisions of the Act and Regulations, the Respondent puts forward three arguments:
1. The word "liability" as used in 1406(b) must be given its ordinary meaning;
2. If the negative reserve amount is a liability then it is a liability in respect of the Appellant's general fund and cannot be excluded by a provision excluding a liability in respect of a segregated fund; and
3. If the negative reserve amount is a liability in respect of segregated funds it is a liability in respect of a guarantee in respect of a segregated fund and thereby expressly excluded from the exclusion in 1406(b).
The word "liability" as used in 1406(b) must be given its ordinary meaning
[52] The Minister argues that the requirement in 1406(b) not to include in MTAR "any liability in respect of a segregated fund (other than a liability in respect of a guarantee in respect of a segregated fund)", cannot include an amount that is not a "liability" in the ordinary sense of the word. The amount that the Appellant failed to include was a negative liability which is not a "liability" in the ordinary sense of the word. The Respondent notes that the word "liability" is not defined in the Act or Regulations. Subsection 1408(1) of the Regulations only defines "reported reserves" and "policy liability".
[53] The Respondent argues that the definition of both "reported reserve" and "policy liability" adopt insurance industry concepts of "reserves" or "actuarial liabilities" which are the end result of a number of calculations. There should be no necessary inference that the amounts calculated for use in arriving at the end results are themselves liabilities as referred to 1406(b). To automatically exclude component calculations, on the basis they are liabilities simply because they are components of a liability calculation, is to misapply the very model that the legislation intends to invoke. Distinct components or subcomponents of actuarial "reserves" or "liabilities" such as the negative reserve amount, are such component calculations and are not by themselves "reserves" or "liabilities". If they are not liabilities in that sense they cannot be excluded pursuant to paragraph 1406(b).
[54] The Minister argues that even in insurance industry parlance, subcomponents in the calculation of actuarial liabilities that are negative reserves or profits of the general fund are not in isolation meant to be taken as liabilities in respect of segregated funds. That they impact the calculation of assets available to pay liabilities to policyholders and thereby impact overall actuarial reserves, does not make them actuarial liabilities any more than they are liabilities in the ordinary sense of the word. The negative reserve amounts do not appear on form OSFI 54 as a final or global liability but rather are only included in the calculation of actuarial liabilities for segregated funds as components or subcomponents of that amount. They cannot be termed "liabilities" as that term is understood for either insurance accounting or income tax purposes and are therefore not a "liability in respect of the segregated fund".
[55] The Respondent furthers this argument by suggesting that since it is agreed, in the Agreed Statement of Facts, that negative reserve amounts are in the nature of future net premium income, they cannot be regarded as a liability.
[56] The Respondent also notes that the reference to the inclusion of negative numbers in subsection 1404(3), section 1407 and section 1408 definitions do not apply to component calculations but rather just refer to end result calculations.
If the negative reserve amount is a liability then it is a liability in respect of the Appellant's general fund and cannot be excluded by a provision excluding a liability in respect of a segregated fund
[57] This argument is based on the fact that both the revenue and expense components of the negative reserve amount (calculated together in arriving at the subcomponent (ii) or negative reserve amount) form part of the Appellant's general fund and never form part of a segregated fund. Further, all of the Appellant's actuarial liabilities in respect of the UltraFlex Policies were ultimately included as part of the Appellant's general fund and the negative reserve amounts reduced the Appellant's general fund liabilities.
[58] It is further argued that the PPM method of computing reserves imposed on Canadian insurers recognizes the fact that the negative reserve amounts are present value amounts in respect of general fund amounts. That is, they modify reserves of the general fund, not reserves in respect of the segregated funds.
If the negative reserve amount is a liability in respect of segregated funds it is a liability in respect of a guarantee in respect of a segregated fund and thereby expressly excluded from the exclusion in 1406(b)
[59] The Respondent argues that since the only future potential liability or insurance risk under the UltraFlex Policies was the minimum death and maturity benefit guarantees, the negative reserve amounts were liabilities in respect of these guarantees and therefore liabilities in respect of a segregated fund which are not to be excluded.
[60] The profit earned in respect of the administration of its segregated funds were a necessary part of the Appellant's overall business accounted for in its general fund which is there to cover its exposure to policyholders which, in respect of UltraFlex policyholders, was nothing other than the guarantee amount. Therefore the negative reserve amount should ultimately be seen as being in respect of that guarantee.
Respondent's Further Arguments
[61] The Respondent raised a fourth argument which was made to counter the Appellant's alternative argument. The Appellant argued that the subcomponent (ii) amount was determined with reference to liabilities and thereby excluded by the express language in paragraph 1406(b).
[62] The Respondent takes the position that the Appellant's alternative argument hinges on all the amounts included in the computation of the negative reserve amount only being determinable with reference to the Appellant's liability in respect of its segregated funds. For example fees to UltraFlex policyholders based on initial contributions or even fund values would not be based on a liability to UltraFlex policyholders where the guarantee amount was the liability amount.[11] As well, it may be inherent in the Respondent's response to the Appellant's alternative argument that "liability" as used in paragraph 1406(b) must necessarily refer to a liability to UltraFlex policyholders as is the case in respect of subcomponents (i) and (iii).
[63] One last argument made by the Respondent needs to be mentioned. It was the Respondent's answer to my enquiries as to the scheme of the Act in respect of insurance companies that would support the Respondent's position that the taxation of future profits was envisioned by Parliament. My enquiry was based on my uncertainty that the Respondent's premise, namely that the financial statements of insurance companies as reported to the Superintendent of Financial Institutions are meant to be adopted for tax purposes, was a supportable premise. While I will deal with the Respondent's answer to this enquiry in my analysis, I note that the Respondent argued in general terms at least that the Act has a symmetry respecting premiums paid for segregated funds that required future income to be recognized as reported to the Superintendent. For example, initial segregated fund premium income is deemed by subparagraph 138.1(1)(e)(ii) not to be an amount paid in respect of the premium under the policy and is therefore excluded from the income of the insurer. The Act could, therefore, not be viewed as intending to allow an insurer who issues segregated fund policies to deduct, in computing its income, reserves in respect of premium income that was excluded from the income of the insurer. The Respondent argued that, in effect, including negative reserve amounts in the calculation of tax reserves was a form of matching given that premiums were not taxed as income.
Analysis
[64] The Appellant's principle argument that the subcomponent (ii) amount, as a required component of its actuarial liability to policyholders with segregated fund investments, is thereby a liability in respect of segregated funds, is not compelling. An isolated factor in determining the quantum of a liability is not necessarily a liability itself. An arithmetic formula targeting the determination of a liability which nets out an amount that reduces that liability cannot render a non-liability into a liability. While it is not in dispute that paragraph 1406(b), taken in context, must refer to the liabilities contained in the actuarial formula prescribed by the PPM in respect of segregated funds, including potentially at least, the subcomponent (ii) amount, there is no necessary inference that all amounts calculated thereunder are themselves liabilities. I agree with the Respondent on this point.
[65] Further, the Appellant's reliance on references to negative amounts being recognized under the Regulations is not supportive of its position in my view. The references that the Appellant seeks to rely on fall short of prescribing either a change in the characterization of the nature of the amount (in terms of it being a liability or not) or a requirement to include or exclude an amount (even a negative amount) in a calculation that is not the result of the particular calculation referred to. That the MTAR calculation of the amount determined by the formula A+B+C+D-M can be positive or negative does not suggest that the calculation of the "A" amount must either treat a non-liability as a liability or dictate the inclusion or exclusion of a negative subcomponent (ii) amount in the calculation of a component of that calculation. Similarly, that the "A" amount itself (reported reserves or policy liabilities) can be a negative amount does not suggest that the calculation of the "A" amount must either treat a non-liability as a liability or dictate the inclusion or exclusion of a negative subcomponent (ii) amount in the calculation of a component of the calculations that produce the "A" amount. In other words, the Appellant's argument that since the reported reserves and policy liabilities can be negative, the necessary inference is that "liabilities" can be negative, is simply not correct in my view.
[66] While the for greater certainty provision in section 1407 of the Regulations[12] does have broader scope in permitting negative numbers to remain in calculations that are determinative of amounts calculated under section 1404 and likely ensures that, but for paragraph 1406(b), the negative reserve amount stays in the calculation of the MTAR, that does not suggest that it is a "liability" for the purposes of paragraph 1406(b).[13] Whether an amount is a liability should not depend on its positive or negative orientation in a formula incorporating it. As it happens, if the subcomponent (ii) amount was positive, it would be a liability and in my view properly be excluded under paragraph 1406(b) as, incidentally, an auditor of the Canada Revenue Agency ("CRA") also conceded.[14] That does not mean that the calculation always gives rise to a liability.
[67] That the Appellant fails to gain ground by relying on its principle argument and on the provisions relating to negative numbers is not to say such failure is fatal to its appeals.
[68] Indeed, the Appellant's alternate argument has persuaded me that the appeals must succeed. Recall that that argument relies on paragraph 1406(b) requiring that the calculation of any amount under section 1404 be done "without reference to any liability in respect of a segregated fund" (emphasis added). Reported reserves and policy liabilities are amounts calculated under section 1404 and must be calculated without reference to any liability in respect of a segregated fund. The subcomponent (ii) amount is calculated with reference to liabilities. Whether or not it is itself a liability, it is not an amount that can be determined without reference to liabilities. It is a number inextricably tied to liabilities in respect of segregated funds. If that alone is not sufficient to find that paragraph 1406(b) expressly requires the exclusion of the negative reserve amount, it becomes necessary in my view to abandon the holistic approach of focusing on that amount. The focus must then be on the components of the negative reserve amounts. These are amounts determined in respect of the Appellant's segregated funds. If they are liabilities in respect of segregated funds they must be excluded from the calculation of reserves for tax purposes according to the express charge in paragraph 1406(b).
[69] One component of the subcomponent (ii) amount is projected gross fees payable to the Appellant by UltraFlex policyholders. If this is not a liability under paragraph 1406(b) it stays in the reserve calculation for tax purposes and thereby reduces the reserve amount for tax purposes. The other component, the expense component in subcomponent (ii), is a liability of the Appellant (in the ordinary sense of the word) and would be taken out of the reserve calculation for tax purposes pursuant to paragraph 1406(b). The present value of gross projected revenues from policyholders would then become the subcomponent (ii) amount for tax purposes and would be applied, as negative number, to reduce the one liability allowed under 1406(b), namely the subcomponent (iii) amount (the guarantee). This gives a result that neither party advocates but it is a result that follows the application of the ordinary meaning of the word "liability" as used in paragraph 1406(b).[15]
[70] It also reads in a requirement that the liability referred in paragraph 1406(b) be a liability of the Appellant. The policyholder's liability to the Appellant in respect of fees is not excluded as a liability in the above construction of paragraph 1406(b). Yet, by not excluding such liability - the formula does not yield an answer that either party suggests is intended.
[71] In fact, there is no suggestion in the subject provision that such liability (the policyholder's liability to the Appellant) not be excluded. Paragraph 1406(b) refers to any liability in respect of a segregated fund. The liability of policyholders to the Appellant meets this requirement. Taking out this component of the subparagraph (ii) amount, as well as the expense component, leaves that amount at nil. This is the result the Appellant advocates although the Appellant's approach was to go one step further and argue that the policyholder liabilities in respect of segregated funds are themselves computed by reference to the Appellant's liabilities to the policyholders and are thereby excluded under paragraph 1406(b). Either way, I am satisfied that the Respondent's approach simply does not work. A holistic approach to viewing the subcomponent (ii) amount as the amount to examine is not invited by paragraph 1406(b). As a single amount it cannot be determined without reference to liabilities (even just third-party liabilities) and as such must be excluded with or without peeling back more and more layers to reveal as the Appellant has done that the core elements of the subcomponent (ii) amount all refer back sooner or later to liabilities of the Appellant to third parties or to policyholders all in respect of its segregated funds.
[72] In short then, once the holistic approach to the paragraph (ii) amount is abandoned there is no way in my view to apply paragraph 1406(b) on its express terms and give the result assessed by the Minister. In such case the appeals in my view must be allowed. If there is any doubt to this conclusion I note that such doubt derives from uncertainty in the language employed in paragraph 1406(b). Inserting a generally worded tax reserve provision into a maze of external actuarial reserve formulations measuring something quite distinct from a tax reserve has made the construction of the subject provision uncertain. In such case, deference to a meaning more favourable to the taxpayer must be given.[16]
[73] I have not reached this conclusion without being mindful that the Respondent's construction of paragraph 1406(b) would have the affect of taxing projected future profits.[17] This has struck me from the outset as contrary to the general scheme of the Act. On the other hand there may be little about the taxation of insurance companies that is consistent with the scheme of the Act so I have been cautious not to rely on an underlying purpose that might assist in the construction of paragraph 1406(b).
[74] However, that is not to ignore submissions made in respect of the purpose of that paragraph. I will address those but first I would like to point out that my initial inclination to see the Respondent's position, which seeks to bring projected future profits into income, as contrary to the scheme of the Act was fed by a reading of the subject provisions that might be said to expressly prohibit taxing projected future income.
[75] Subsection 1404(3) is the provision under which reserves are calculated for tax purposes. It allows a reserve of the lesser of reported reserves and policy liabilities. Both of these amounts, as calculated in respect of segregated funds (which is all I have been referred to), include projected future income to the extent that is what the subcomponent (ii) amount represents. One does not have to go then to paragraph 1406(b) to find that this subcomponent must be taken out of the insurance reserve. The exclusion is found in the definitions of "reported reserves" and "policy reserves" as set out in section 1408 of the Regulations. They expressly require that the MTAR be calculated "without reference to projected income":
"policy liability" of an insurer at the end of the taxation year in respect of an insurance policy ---- means the positive or negative amount of the insurers reserve in respect of its potential liability in respect of the policy ---- determined in accordance with accepted actuarial practice, but without reference to projected income and capital taxes (other than the tax payable under Part XII.3 of the Act). [emphasis added]
"reported reserve" of an insurer at the end of a taxation year in respect of an insurance policy --- means the amount equal to
(a) where the insurer is required to file an annual report with its relevant authority for a period ending coincidentally with the year, the positive or negative amount of the reserve that would be reported in that report in respect of the insurer's potential liability under the policy if the reserve were determined without reference to projected income and capital taxes (other than the tax payable under Part XII.3 of the Act); [emphasis added]
[76] It is unsettling to think I might have disposed of these appeals on the basis of what appears on the surface to be a clear answer to the issue put before me without scratching that surface to see what impact it might have on other calculations in other contexts. Had the parties dealt with this approach, such concerns would have been aired. They did not. That being the case, I have not relied on such approach as the basis for allowing the appeals. It has not been necessary as I am satisfied that the Appellant's alternative argument is sufficiently persuasive on its own.
[77] This takes me back to consider the Respondent's arguments as to the scheme of the Act. I invited them to better understand the Respondent's mindset in reading the subject provisions in a manner that would tax future projected profits. Having invited such arguments I do not now want to ignore them.
[78] The Respondent argued that the Act cannot be viewed as intending to allow an insurer with segregated funds to deduct reserves in respect of premium income when premium income in respect of segregated funds is not brought into income in the first place (see subparagraph 138.1(1)(e)(iii) of the Act). The premium income amounts referred to are the segregated fund deposits. For tax purposes they are held in trust for the policyholders. In that sense they are not income for tax purposes. I see no reason, in that context, to assume that the Act should be taken as requiring that future income projected from the administration of segregated funds be brought into income.
[79] Along the same lines the Respondent referred me to certain amendments to the Act and Regulations that the Respondent argues require the inclusion of negative reserve amounts in the calculation of reserves or reflect a policy that the negative reserve amount under subcomponent (ii) must be so included. Paragraph 138(4)(b) of the Act was added effective for 1996 and subsequent years to bring the amount prescribed under subsection 1404(2) of the Regulations into income. Subsection 1404(2) prescribes that the income inclusion is the absolute amount determined under subsection 1404(3). This only means that if the MTAR formula in subsection 1404(3) (A+B+C+D−M) is negative, such negative amount is brought into income. This does not suggest that the negative reserve amount determined under subcomponent (ii) must be brought into income or that such negative liability amount cannot be omitted from the reserve for tax purposes pursuant to paragraph 1406(b).
[80] Still attempting to persuade me that the scheme of the Act required me to find that the negative reserve amount determined under subcomponent (ii) must be left in the calculation of reserves for tax purposes, the Respondent argued that the Act should be seen as requiring a matching of incomes and expenses in respect of segregated funds which is best reflected by the actuarial and GAAP treatment. The uncertainty in the language in paragraph in 1406(b) should be resolved in favour of following the financial picture presented to the Superintendent of Financial Institutions.
[81] As to the matching argument I was given examples at the hearing by both parties. They were meant to provide some insight as to effect of the parties' positions. However they failed in that regard. Indeed they left me with more questions. It is worth noting however that the starting point of those examples seemed to focus on an heretofore unmentioned limitation on the calculation of the negative reserve amount. Effective for the subject and later years, CIA guidelines followed by the Appellant, put a limitation or "cap" on the negative reserve amount determined under subcomponent (ii). The contingent future profits that could be recognized were limited to the Appellant's deferred acquisition costs in respect of its segregated funds and the guarantees under subcomponent (iii). In effect then the extra reserve that the Appellant claimed for tax purposes (by arguing that paragraph 1404(b) excludes the negative liability amount) permitted a reserve expense of its deferred acquisition costs in respect of its segregated funds as well as permitting a reserve expense in respect of its guarantees.[18]
[82] It may well be that this result, particularly as it results in the acceleration of expensing deferred acquisition costs, was not intended by Parliament. It may be that the actuarial accounting approach does reflect a solid basis for presenting the financial status of insurers in this respect. However this only begs the question as to whether the Act embraces such approach.
[83] In this regard it must be kept in mind that the actuarial reports to the Superintendent serve a particular purpose. Even the cap on the negative liability amount referred to above serves a monitoring purpose. The negative liability amount (projected profits) for insurance purposes bloats the reserve comfort of the insurer - the insurer will appear asset enhanced. To give policyholders more comfort, a cap or containment is required. That the containment employs a matching against certain costs for insurance industry purposes, is irrelevant in my view to the issue before me which is to determine whether the negative reserve amount (projected profits) reduces its MTAR. Again that question begs the question as to whether the financial picture presented to the Superintendent of Financial Institutions is the picture dictated by the Act for tax purposes.
[84] Ultimately this is the heart of the issue as presented by the Respondent. All the Respondent's arguments are made to support the position that the reserve for insurance purposes presents the best financial picture of insurers and should govern. This portrayal of the Respondent's position is best seen in the following excerpt from the Respondent's written submission:
... If the insurer takes into account a future profit (and the Appellant did with respect to its UltraFlex Policies), this will have the effect of increasing its reported surplus. This increase in surplus can be reflected in the balance sheet only through an increase in its assets or through a reduction of its liabilities. The Appellant chose the latter course, all in keeping with generally accepted actuarial practice, and increased its surplus and thus enhanced its liquidity and capacity to carry on business. The reduction of the Appellant's liabilities by these future profits was therefore deliberate and based on good and valid business reasons from which the Appellant cannot resile when computing its income for income tax purposes.
[85] Such position in my view simply carries no weight. The financial picture that the Respondent wants the Appellant tied to is not designed to determine the most accurate measure of income as was the exercise in such cases as Canderel Limited v. The Queen.[19] Here the measurement that the Respondent seeks to adopt as more accurately measuring income, is in fact a measurement that generally accepted actuarial practice employs to assess the insurer's ability to pay its liabilities.
[86] That GAAP endorses the actuarial approach used to monitor insurance companies does not suggest to me that it best reflects the income of the Appellant in the subject years. Indeed that it does not, is suggested by the very existence of subsection 1406(b) which prescribes an adjustment to the actuarial approach. Subsection 1404(3) is the provision under which reserves are calculated. No deduction is allowed for reserves under the Act except for amounts calculated under this provision. Even reserves calculated for the Superintendent or by generally accepted actuarial practices or by generally accepted accounting principles are not allowed. What is allowed whether consistent with any of these reserves so calculated or not, whether they reflect business realities as portrayed by these reserve calculations or not, is what 1404(3), calculated pursuant to paragraph 1406(b), allows. That is its purpose and on its terms as calculated pursuant to paragraph 1406(b), I am of the view that it takes out the projected profit or loss determined under subcomponent (ii). While the result of this construction is more generous than the actuarial and accounting treatment otherwise dictated, it is a result that does not offend any more than would a faster depreciation rate being allowed under the Act than afforded under GAAP. Barring faster recognition of expenses against future projected profits is not for me to legislate. If Parliament wished to bar it, Parliament might have done so more clearly.
[87] Before concluding these Reasons it is necessary that I briefly address the Respondent's alternative arguments and a few case authorities cited by the Respondent.
[88] The Respondent's alternative arguments are long reaches at best. They suggest that subcomponent (ii) is in respect of the general fund and the guarantee. Considering that each component of the subcomponent (ii) calculation either goes into or comes out of the general fund, the Respondent is correct in suggesting that the subcomponent (ii) amount can only impact the general fund. Nonetheless it is simply not correct to say that the negative reserve amount is not in respect of the segregated funds. Every component, every dollar, of subcomponent (ii) is calculated in respect of a particular segregated fund policy. As the Appellant argues, the subcomponent (ii) amount does not exist if there were no segregated funds.
[89] I do acknowledge a more significant connection between the subcomponent (ii) amount and the guarantee accounted for as the subcomponent (iii) amount.[20]
[90] While it is clear that the connection is not such as would detract from the conclusion that the subcomponent (ii) amount is an amount calculated with reference to a liability in respect of segregated funds, the question might still be asked as to whether the negative reserve amount, calculated with reference to a liability in respect of segregated funds, is also a liability in the respect of the guarantee. If so, paragraph 1406(b) might well require that the negative reserve amount be included in the MTAR calculation. Considering the connection, I am still of the view that it would not be correct to say that the negative reserve amount is a liability in respect of the guarantee. As well, looking at the components of subcomponent (ii) amount, neither is a liability that is calculated with reference to the guarantee. I have already concluded that it is not a liability. As well, looking at the components of subcomponent (ii) amount, neither is a liability that is calculated with reference to the guarantee.
[91] I turn now to case authorities cited by the Respondent. In Double N Earth Movers Ltd. v. Canada[21] the construction of a phrase used in the Excise Tax Act in the context of surface mining techniques was considered. The Court considered "ordinary meaning" versus "technical meaning" and concluded ordinary meaning may be rejected in favour of technical meaning where the persons being regulated would have understood the regulatory provision according to its technical meaning. This is a question of fact.
[92] Considering both the insurance industry's view of the interplay between subcomponent (ii) and paragraph 1406(b) and the "ordinary meaning" view of that interplay, this construction aid offers no better resolution in my view of the subject provisions than the one afforded by the Appellant's alternative argument. Indeed if the word "liability" were given a "technical" meaning it would arguably have the meaning attributed to it by the Appellant under its primary argument, namely, the "liabilities" to be excluded from the reserve calculations under paragraph 1406(b) must include the negative liability amount determined under subcomponent (ii) because it is included as part of the overall liability for insurance purposes.
[93] In Maritime Life Assurance Co. v. Canada[22] the Court held that investment administration fees charged to administer segregated funds were not fees for services. The Court held that moving money from segregated funds to a general fund did not make the payment a fee for services even if the segregated funds were regarded as a separate person for tax purposes. The Court saw the fees as premium revenue from the annuity policies in respect of which the fees were charged and as such were not a taxable supply for GST purposes.
[94] I do not see how this decision assists the Respondent's position. Whether the fees charged to segregated fund policyholders are premium revenues or fees for services for GST purposes, the question is the same for income tax purposes: does paragraph 1406(b) exclude amounts calculated by reference to liabilities in respect of the segregated funds in the calculation of reserves for tax purposes? The answer to that is not the subject of the Maritime Life decision. Further, I do not understand the Respondent's position to be that the profit once realized, either as premium revenue or as net fees, will not be income under the Act. As asserted by the Appellant's example with which the Respondent did not take issue at the hearing, including or excluding the negative reserve amount is a question of timing in respect of the recognition of income. Regardless, the Act does not always give effect to the symmetries that the CRA deems appropriate. That alone rarely dictates a construction of the Act that would ensure that the CRA has its way. [23]
[95] Lastly, I refer to The Queen v. Manufacturer's Life Insurance Company.[24] This decision of the Federal Court of Appeal held that the balance sheet as accepted by the Superintendent of Financial Institutions prevailed in the determination of "taxable capital" for the purposes of calculating the insurer's capital tax liability. In determining whether deferred gains were taxable capital, the Court accepted the balance sheet as accepted by the Superintendent of Financial Institutions because the express provisions of the Act said exactly that. The Act required conformity with the financial reporting accepted by the Superintendent who as it happened in turn relied on GAAP. As such, the Court was satisfied that GAAP was the required method to measure taxable capital in that case.
[96] Clearly the Respondent wants GAAP (which follows generally accepted actuarial practices) to prevail in the case at bar. The Respondent asserts that the reports to the Superintendent of Financial Institutions should be determinative of the inclusion or exclusion of the negative reserve amount determined under subcomponent (ii). However in Manufacturer's Life the Court was looking at specific statutory language directing consistency with the reports to the Superintendent. That is not the case in respect of the appeals at bar.
[97] To conclude, I cannot escape the conclusion that the insurance reserve reported to the Superintendent of Financial Institutions must be adjusted under 1406(b) by excluding the negative reserve amount calculated under subcomponent (ii).
[98] Accordingly the appeals are allowed with costs.
Signed at Ottawa, Canada, this 13th day of October 2006.
Hershfield J.
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