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Date: 20030130
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Docket: 2001-2224(GST)G
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BETWEEN:
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STATE FARM MUTUAL AUTO INSURANCE COMPANY,
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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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AND
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Docket: 2001-2226(GST)G
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BETWEEN:
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STATE FARM FIRE & CASUALTY COMPANY,
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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
Bowman, A.C.J.
[1] These appeals
were heard together and are from assessments of Goods and
Services Tax ("GST") made under the Excise Tax
Act ("ETA"). The issue is whether expenses
of the appellants' head office in Bloomington, Illinois that
were allocated to the Canadian Regional Office ("CRO")
are subject to the GST. There are two assessments for each
company, one covering the period January 1, 1991 to
December 31, 1994 and one covering the period
January 1, 1995 to December 31, 1997.
[2] State Farm Mutual
Auto Insurance Company and its wholly owned subsidiary State Farm
Fire & Casualty Company (collectively referred to as
"State Farm") are licensed to carry on business in
50 states of the United States and three provinces of Canada
(Ontario, Alberta and New Brunswick). State Farm is the largest
automobile, fire and casualty insurer in North America. The
insurance operations are carried on through 25 regional
offices consolidated into 13 zones. The Canadian operation
is a separate zone and the CRO is located in Scarborough,
Ontario. Insurance is sold by independent agents
("agents") operating throughout the three provinces in
which State Farm carries on business in Canada. The CRO is a
permanent establishment of State Farm as defined in
subsection 123(1) of the ETA. The agents are not.
[3] Section 220
of the ETA reads
For the purposes of this Division, where a person carries on a
business through a permanent establishment of the person in
Canada and through another permanent establishment outside
Canada,
(a) any transfer
of personal property or rendering of a service by one
permanent establishment to the other establishment shall be
deemed to be a supply of the property or service;
(b) in respect
of that supply, the permanent establishments shall be
deemed to be separate persons who deal with each other at
arm's length;
(c) the value of
the consideration for that supply shall be deemed to be the fair
market value of the supply at the time the property is so
transferred or the service is so rendered; and
(d) the
consideration for that supply shall be deemed to have become due
and to have been paid, by the permanent establishment (in this
paragraph referred to as "the recipient") to which the
property was transferred or the service was rendered, to the
other permanent establishment at the end of the taxation year of
the recipient in which the property was transferred or the
service was rendered.
[emphasis added]
Paragraph 220(c) was substituted
in 1993, applicable to property transferred and services rendered
after September 14, 1992. It formerly read:
(c) the value of
the consideration for that supply shall be deemed to be the
amount that is, or would be if the person were taxable under the
Income Tax Act, determined with respect to that supply for
the purpose of calculating the income of the permanent
establishments for the purposes of that Act.
[4] The head office
of State Farm in Bloomington, Illinois ("head office")
does a number of things that are essential to its insurance
business. I shall set out later in these reasons for judgment
details on just what it does. It allocates to the various
regional offices throughout North America, including the CRO, the
expenses of these operations on the basis of a mathematical
formula. It is the amounts so allocated that the CCRA has
subjected to the GST as a deemed supply of a service under
section 220.
[5] One may surmise
that if the assessing action of the CCRA under section 220
could be upheld it would have to be implicitly based on the
following premises:[1]
(a) head office
rendered a service to the CRO;
(b) this was deemed
to be a supply of a service rendered by a separate arm's
length person;
(c) the services were
administrative or management services and were accordingly
imported taxable supplies as defined in section 217;
(d) they were not
exempt financial services;
(e) only 1% of
the activity at head office related to underwriting and 5% to
claims;
(f) the
consideration for the supply deemed to have been paid by the CRO
to head office is the amount of the expenses so allocated to the
CRO.
[6] The
appellants' position is:
(a) if the
activities performed by head office are composite supplies, they
are a composite supply of exempt financial services;
(b) in the
alternative if the supply is a mixed supply it is a supply to
which section 139 applies because over 50% of the costs
represent financial services;
(c) in the further
alternative, if it is a mixed supply to which section 138
applies, the costs allocated to the CRO are incidental to the
supply to the customers of an insurance policy;
(d) substantially all
of the head office activities are performed by employees and so
they are not "services" as defined in
subsection 123(1);
(e) the
allocation of expenses by head office to the CRO while necessary
for regulatory purposes and the determination of profit for
Canadian income tax and accounting purposes does not constitute a
consideration for a service that is "rendered" to the
CRO by head office;
(f) the last
argument is taken directly from the appellants' written
opening statement. It reads
From neither a plain meaning nor a policy
perspective should GST be exigible on these expense
allocations.
[7] Since the essence
of the appellants' argument is that if head office performed
a service for the CRO it was an exempt financial service, I shall
set out the relevant statutory provisions upon which the
appellants rely.
[8]
Subsection 123(1):
"taxable supply" means a supply
that is made in the course of a commercial activity;
"commercial activity" of a person
means
(a) a business
carried on by the person (other than a business carried on
without a reasonable expectation of profit by an individual, a
personal trust or a partnership, all of the members of which are
individuals), except to the extent to which the business
involves the making of exempt supplies by the person,
...
[emphasis added]
Paragraph (a) in the definition
of commercial activity was amended in 1997, deemed to have come
into force on April 24, 1996. It formerly read:
(a) a business
carried on by the person (other than a business carried on by an
individual or a partnership, all of the members of which are
individuals, without a reasonable expectation of profit), except
to the extent to which the business involves the making of exempt
supplies by the person.
Paragraph (a) was first
substituted in 1993, applicable after September 1992. It formerly
read:
(a) any business
carried on by a person.
"exempt supply" means a supply
included in Schedule V.
[9] Part VII of
Schedule V reads in part
1. A supply of a
financial service is not included in Part IX of Schedule
VI.
2. A supply
deemed under subsection 150(1) of the Act to be a
supply of a financial service.
[10]
Subsection 123(1):
"financial service" means
...
(d) the
issue, granting, allotment, acceptance, endorsement,
renewal, processing, variation, transfer of ownership or
repayment of a financial instrument
...
(f) the
payment or receipt of money as dividends (other than
patronage dividends), interest, principal, benefits or any
similar payment or receipt of money in respect of a financial
instrument,
...
(h) the
underwriting of a financial instrument,
...
(l) the
agreeing to provide, or the arranging for, a service
referred to in any of paragraphs (a) to (i)
...
but does not include
...
(t) a
prescribed service.
[emphasis added]
"financial instrument" means
...
(c) an insurance
policy,
...
"insurance policy" means
(a) a policy or
contract of insurance (other than a warranty in respect of the
quality, fitness or performance of tangible property, where the
warranty is supplied to a person who acquires the property
otherwise than for resale) that is issued by an insurer,
including ...
"service" means anything other
than
(a)
property,
(b) money,
and
(c) anything
that is supplied to an employer by a person who is or agrees to
become an employee of the employer in the course of or in
relation to the office or employment of that person.
[emphasis added]
[11] Section 139:
For the purposes of this Part, where
(a) one or more
financial services are supplied together with one or more other
services that are not financial services, or with properties that
are not capital properties of the supplier, for a single
consideration,
(b) the
financial services are related to the other services or the
properties, as the case may be,
(c) it is the
usual practice of the supplier to supply those or similar
services, or those or similar properties and services, together
in the ordinary course of the business of the supplier, and
(d) the total of
all amounts, each of which would be the consideration for a
financial service so supplied if that financial service had been
supplied separately, is greater than 50% of the total of
all amounts, each of which would be the consideration for a
service or property so supplied if that service or property had
been supplied separately,
the supply of each of the services and
properties shall be deemed to be a supply of a financial
service.
[emphasis added]
Section 139 was substituted in 1993,
applicable to supplies made after September 14, 1992. It
formerly read:
For the purposes of this Part, where a supply of one or more
financial services is made together with one or more properties
or services that are not financial services and the total of all
amounts, each of which would be the consideration for a financial
service so supplied if that financial service had been supplied
separately, is greater than 50% of the single consideration, the
supply of all the properties and services shall be deemed to be a
supply of financial services.
[12] Section 138:
For the purposes of this Part, where
(a) a particular
property or service is supplied together with any other property
or service for a single consideration, and
(b) it may
reasonably be regarded that the provision of the other property
or service is incidental to the provision of the particular
property or service,
the other property or service shall be deemed
to form part of the particular property or service so
supplied.
[13] Section 218:
Subject to this Part, every recipient of an imported taxable
supply shall pay to Her Majesty in right of Canada tax
calculated at the rate of 7% on the value of the consideration
for the imported taxable supply.
[emphasis added]
Section 218 was amended in 1997, in
force April 1, 1997 (subsection 218(2) has been moved
to section 218.2). It formerly read:
(1)
Subject to his Part, every recipient of an imported taxable
supply shall pay to Her Majesty in right of Canada a tax equal to
7% of the value of the consideration for the imported taxable
supply.
(2)
The tax under this Division on an imported taxable supply is
payable by the recipient on the earlier of the day the
consideration for the supply is paid and the day the
consideration for the supply becomes due.
[14] Section 217:
In this Division, "imported taxable supply" means
(a) a taxable
supply (other than a zero-rated or prescribed supply) of a
service made outside Canada to a person who is resident in
Canada, other than a supply of a service that is ...
[emphasis added]
[15] In each case where
emphasis has been added it is to indicate the portions of the
provision upon which the appellants specifically rely.
[16] I shall begin my
analysis by describing the respective roles of the agents, the
CRO and the head office.
[17] The insurance business
can be divided into four broad categories:
(a)
underwriting, which encompasses writing the policies, determining
the type of risks that will be underwritten, determining the
price of coverage, determining the policy endorsements and what
markets will be targeted;
(b) sales of
policies, called acquisition;
(c) settling and
payment of claims; and
(d) investment of
funds needed to comply with the legal requirement for investing
to cover reserves.
The Agents
[18] The agents sell the
policies to customers. They meet the customers, discuss rates,
feed the relevant information about the customers into the
computer and, using programs developed at head office (the
"ECHO System"), determine the customers'
insurability and the rates that the insured will pay. This is a
purely mechanical computer generated process involving no element
of discretion or judgement on the part of the agents. The agents
have the authority to bind State Farm by issuing a pink slip
evidencing coverage the moment an approved insurance application
is completed. The form of application is developed at head office
under the ECHO System and the insurance policy that is issued to
the insured is in the form developed at head office.
[19] Claims made under a
policy are in the vast majority of cases reported to the agents
who complete a loss report on the ECHO System. Small claims
(formerly $2,000 and now $5,000) can be paid directly by the
agents. All claims are reported to the CRO.
The CRO
[20] When an application is
completed and coverage provided the agent submits the completed
application and insurance contract to the CRO. CRO checks it to
ensure that the information is correct and that the risks meet
the criteria established in head office. CRO determines whether
the rates are correct in accordance with head office criteria or
whether the insured has made any misrepresentation (such, for
example, as failure to disclose convictions for traffic
offences).
[21] If an error was made
affecting the customer's rate the CRO would adjust the rate
(up or down) and inform the customer. If the customer objects to
the adjustment the policy is terminated. If the misrepresentation
is serious enough to warrant termination the coverage is
terminated upon notice to the insured. The vast majority of
contracts are accepted as submitted and terminations are very
rare.
[22] The CRO is not
involved in the selling of insurance. If a prospective customer
wants to buy insurance he or she is referred to an agent.
[23] Where a claim is made
to an agent a loss report is made to the CRO on the ECHO System.
If the claim is beyond the limit payable by the agent the CRO
reviews the claim, notes it in the system and sets a claim
reserve. This information goes into the head office database.
[24] Apart from the small
claims handled by the agents the CRO handles virtually all
claims, including litigation. It has its own adjusters and
investigators. On very rare occasions CRO may consult head office
in respect of a claim.
[25] CRO carries out the
investment transactions in Canada in accordance with the
directions of head office, which makes the investment decisions.
The reserves are in accordance with the provisions of the
Insurance Act. The portion of the head office expense
attributed to investments that is allocated to the CRO is not in
issue in these appeals.
Head Office
[26] Since it is the
expenses of head office allocated to the CRO that are the subject
of these appeals and that the Minister considers to be in respect
of taxable supplies, I shall endeavour to describe with some
particularity what head office does.
[27] Before I do so, one or
two preliminary observations should be made. The basic assumption
as pleaded was that the
Appellant's head office rendered Head
Office or management Services to the Canadian Branch with respect
to policies issued to Canadians.
[28] No assumption was
pleaded and no fact alleged with respect to the value of the
consideration or the fair market value of the supply.
[29] The Minister's
unpleaded assumption that one percent of the expenses related to
underwriting and five percent related to claims was disclosed in
the examination for discovery of an officer of the Crown that was
read into the record.
[30] While it is true that
section 220 of the ETA deems the foreign permanent
establishment and the Canadian permanent establishment to be
separate persons dealing at arm's length and effect must be
given to that deeming provision, the fact remains that head
office and the various regional offices including the CRO are all
part of one single economic entity (strictly speaking, two
corporations). Paragraph (a) of section 220
requires that there be a rendering of a service by one permanent
establishment to another. What is deemed is
(a) that the
two permanent establishments are separate arm's length
persons; and
(b) if there is a
rendering of the service it is deemed to be a supply of the
service.
[31] That is as far as the
statutory fiction goes. No statutory fiction is created in
section 220 that deems an accounting allocation of a portion
of a head office expense to be evidence of the rendering of a
service or that the amount so allocated is equal to the fair
market value of the service. Whether a service is rendered by the
head office to the CRO (a condition precedent to the application
of section 220) and what the fair market value, if any, is
of such a service is something that must be determined
independently of any deeming provision. The Crown's failure
to plead any assumptions or facts in this respect might well, in
itself, have been sufficient to justify allowing the appeals.
[32] At all events I think
the function performed by head office is something that must be
determined separately from the question whether a service is
being rendered.
[33] At head office the
following functions are performed.
Underwriting
[34] Before I describe the
role of head office in the underwriting function it is important
that I set out just what I understand this term to encompass. The
determination of the meaning of words in a statute is generally
regarded as a question of law although there is some respectable
authority to the effect that it may involve a question of fact or
a mixed question of fact and law. For example in Girls'
Public Day School Trust v. Ereaut, [1931] A.C. 12, Lord
Warrington of Clyffe, in referring to a decision of
Denman J. in Blake v. The Mayor of the City of
London, 18 Q.B.D. 437; 19 Q.B.D. 79, said
at p. 28:
Denman J., in giving judgment in the
King's Bench Division, makes some remarks very apposite to
the present case. He says (at p. 444): "There is no
definition of a public school to be found in any text-book or Act
of Parliament. The question, therefore, seems to me to be a mixed
question of law and fact, and indeed is very much in the nature
of a question of fact," and at p. 445, "I do not think
that the words 'public school' in this Act must be
construed as words of art. The question is what is the common
understanding of those words, and that is a question not of law
but of fact." With the views so expressed I agree.
[35] Whether the meaning of
underwriting in the ETA is a question of fact, law or
mixed fact and law, it must be construed within the context of
the statutory provisions in which it is found. I propose
therefore to look to three sources for guidance.
(a)
Dictionaries.
In Craies on Statute Law, 7th Ed., the
following appears at p. 161:
No doubt reference to the better dictionaries does afford, either
by definition or illustration, some guide to the use of a term in
a statute. Lord Coleridge said, in R. v. Peters: "I
am quite aware that dictionaries are not to be taken as
authoritative exponents of the meanings of words used in Acts of
Parliament, but it is a well-known rule of courts of law that
words should be taken to be used in their ordinary sense, and we
are therefore sent for instruction to these books." And in
Camden (Marquis) v. I.R.C., Cozens-Hardy M.R. said:
"It is for the court to interpret the statute as best it
may. In so doing the court may no doubt assist themselves in the
discharge of their duty by any literary help they can find,
including of course the consultation of standard authors and
reference to well-known and authoritative dictionaries."
(b) Departmental
practice and interpretation.
Departmental interpretations are of course
not binding but they can be of assistance. In Silicon Graphics
Limited v. The Queen, 2002 DTC 7112 at p. 7120
the Federal Court of Appeal made the following observation.
[52] Of course, statements by
Revenue Canada officials are not declarative of the law. However,
in the recent case of Canadian Occidental (U.S.) Petroleum
Ltd. v. The Queen, [2001] DTC 295 (T.C.C.), Bowman, A.C.J.
noted that while the administrative position of Revenue Canada is
not declarative of the law, it is nonetheless of assistance in
circumstances where the Minister seeks to reassess the taxpayer
in a manner inconsistent with its own administrative position.
Associate Chief Justice Bowman wrote at 299:
The Court is not bound by departmental practice although it is
not uncommon to look at it if it can be of any assistance in
resolving a doubt: Nowegijick v. The Queen et al., 83 DTC
5044. I might add as a corollary to this that departmental
practice may be of assistance in resolving a doubt in favour of a
taxpayer. There can be no justification for using it as a means
of resolving a doubt in favour of the very department that
formulated the practice.
(c) The usage within
the industry as understood by an expert.
In Redford v. M.N.R.,
71 DTC 5053, Walsh J. referred to the opinion of
an expert accounting witness to determine the meaning of
"capital gain" or "capital loss" in the
absence of specific definitions.
Dictionaries
[36] A useful starting
point is found in the Dictionary of Insurance (Lewis E.
Davids):
Underwriting The process
of selecting risks for insurance and determining in what amounts
and on what terms the insurance company will accept the risk.
[37] The Oxford English
Dictionary (Second Edition):
Underwrite
2. ...
b. To
subscribe (a policy of insurance) thereby accepting the risk of
insurance.
c. To
carry on the business of insurance.
[38] The Random House
Dictionary of the English Language (2nd Ed.):
Underwrite 1. to write under or
at the foot of, esp. under other written matter. 2. to
sign one's name, as to a document. 3. to show
agreement with or to support by or as if by signing one's
name to, as a statement or decision. 4. to bind oneself to
contribute a sum of money to (an undertaking): Wealthy music
lovers underwrote the experimental concerts. 5. to
guarantee the sale of (a security issue to be offered to the
public for subscription). 6. Insurance. a.
to write one's name at the end of (a policy), thereby
becoming liable in case of certain losses specified in the
policy. b. to insure. c. to assume liability to the
extent of (a specified sum) by way of insurance. d. to
select or rate (risks) for insurance. -v.i. 7. to
underwrite something. 8. to carry on the business of an
underwriter. [1400-50; late ME, trans. of L subscribere to
write underneath, sign, SUBSCRIBE]
Departmental Interpretation
[39] The second source to
which I turn is the CCRA's own interpretation.
[40] On the examination for
discovery of the representative of the CCRA counsel read to the
witness a portion of a GST interpretation on Paramedical Services
Used in the Underwriting of a Life Insurance Policy.
81.
Q. No, I'm not
asking you what you did. I'm asking you a very specific
question. Did you make an inquiry in relation to what the
CCRA's views are as to what constitutes the elements of an
insurance business and hence a financial service during the
period this audit was undertaken? Yes or no?
A. We did not.
82.
Q. Maybe this will
assist you, then. I'll ask you to now turn to Exhibit A-8,
which is the GST Interpretation on Paramedical Services Used in
the Underwriting of a Life Insurance Policy and, at least for the
consumption of the public, this is what one can discern regarding
the CCRA position. If I could ask you to turn to page 2 of that
analysis, have you ever seen this document before?
A. I have not.
83.
Q. So you did not see
it at the time of the audit.
A. I did not.
84.
Q. I'll read it in
for the purpose of the record, and the passage is somewhat
lengthy. Under Analysis, the Agency states in this document which
was released March 23, 1998:
"We agree that the underwriting of an
insurance policy is included under paragraph (h) of subsection
123(1) of the definition of 'financial service' as an
exempt financial service. The position of the department is that
the process of the underwriting of a financial instrument
applies, in this instance, to an insurer as it is the insurer who
is undertaking to enter into the contract of insurance.
"In the underwriting process as it
applies to the insurance industry, it is our view that the
underwriting must evaluate whether to accept or reject a risk for
insurance. In the process of underwriting an insurance policy,
the insurer usually considers the following: an application for
insurance; rating the risk and evaluating the potential for loss;
deciding whether to accept the risk for insurance; extent of
coverage of insurance and the cost to insure.
"Underwriting is a multistage process
involving an approval (or rejection) of the risk by the
underwriting department of the insurer which is required before
the policy will be issued. Normally the whole process of
underwriting is performed by the insurer who underwrites and
issues an insurance policy. Underwriters base their underwriting
decisions on specific data which enable them to evaluate the risk
element in underwriting. The information and services normally
used by underwriters may include actuarial services (necessary
for rating the policy), inspection, investigating, credit rating
and administrative services. After weighting all necessary
information obtained through those services the underwriter
decides whether the risk in question is the type the insurance
company wants to underwrite, or is willing to
underwrite."
Do you have any reason to believe that the statement made by the
Agency in regard to its understanding of this element of the
insurance business does not reflect a correct statement of the
Agency's view?
MR. ERLICHMAN: Do you know?
THE DEPONENT: I don't know.
85.
BY MRS. VAN DER HOUT:
Q. If this publicly
published document regarding the Agency's view of subsection
123(1) of the Excise Tax Act does not represent the
Agency's current view or its view as to what properly
constitutes underwriting in the insurance context, could you
please advise?
MR. ERLICHMAN: Yes, we will undertake that.
[41] In response to the
undertaking given in question 85, counsel for the respondent
wrote as follows:
Page 21, Question 85:
The interpretation referred to is the
CCRA's administrative position.
Expert opinion
[42] The appellants called
as an expert witness Mr. David J. Oakden. He was highly
qualified. I quote a portion of his curriculum vitae:
David J. Oakden is a Principal of Tillinghast
- Towers Perrin responsible for the Property and Casualty
consulting practice in the Toronto office. He first joined
Tillinghast in 1985 and rejoined the firm in 1999 after 3 years
as Senior Vice President and Chief Actuary for Zurich Canada. Mr.
Oakden is a Fellow of the Canadian Institute of Actuaries and the
Casualty Actuarial Society, an Associate of the Society of
Actuaries and a Member of the American Academy of Actuaries. He
graduated from the University of Toronto in 1973 with a doctorate
in mathematics.
[43] A portion of his
report reads as follows.
I. NATURE
OF INSURANCE
Insurance is a promise to pay if a specified
future event occurs (e.g. an automobile accident) in exchange for
a consideration (i.e. a premium). The promise is contained in a
contract, which is often all the customer sees since most
customers do not have claims under their policies.
The basic functions of the insurance company
are
∎Acquisition,
∎Underwriting,
∎Claims, and
∎Investment.
This split is so basic that all companies
engaged in the insurance business in the US and Canada are
required to assign all of their expenses to five categories which
correspond to the above four functions, as well as a category for
taxes (other than federal taxes and real estate
taxes)("Taxes"). These five categories are shown in
Appendix A. The details of these four insurance functions are
discussed below.
Acquisition
Acquisition in the insurance context involves
the sale of an insurance product. The acquisition process is
similar to the sales processes in most businesses. In the
industry, generally, that function is assumed by agents or
brokers. In the case of State Farm, it uses agents who are
independent contractors.
Acquisition includes the following:
-
procuring business and developing the sales force;
-
writing policy contracts;
-
receiving premiums and paying commissions;
-
advertising.
Underwriting
Underwriting is fundamentally comprised of
the following:
- the
design of the product the company is willing to sell;
- the
pricing of the policy that the company has decided to sell;
- the
gathering of relevant information from a potential insured in
respect of a potential sale of insurance; and
- the
process of reviewing the application and the decision of whether
to continue the policy as issued or, in exceptional cases, modify
it.
Claims
Claims is fundamentally concerned with:
- the
development of policies and procedures for discharging the
insurer's responsibility to pay the claims;
-
receiving the claims;
-
verifying that the claim is covered by the policy;
-
determining the appropriate amount of the claim;
-
providing assistance to the insured in dealing with the loss;
and
-
paying the claim.
Between the time when the claim is first
reported and the time the final payment is made, the claims
department is responsible for estimating the total cost of the
claim.
Investment
Investment is the management of the funds
received by the insurance company in relation to its
business.
Other
In addition to the basic insurance functions
described above, insurance companies, like all companies, have
administrative and support services to support the individuals
who carry out the insurance functions, as set out above.
[44] I think the above
definitions, departmental interpretation and expert opinion are
accurately descriptive of the underwriting function when it is
used with reference to a financial instrument such as an
insurance policy. In section 123 of the ETA I can see
no reason to treat it as a "word of art", to use the
expression of Denman J. or as having a special or technical
meaning. It is used in its ordinary sense and it must be
construed in the context in which it is used in the statute, that
is to say, within the provisions of the ETA relating to
financial services.
[45] The underwriting
function is integral to the insurance business. It is an
important aspect of what head office does. In Bloomington,
Illinois the insurance policies are drafted and the procedures
developed whereby they are sold and issued. Head office
determines the level of risk, the type of insurance offered, the
rates and the amount of insurance to be sold in a particular
market. It gathers information from its branches throughout North
America which it analyses with its underwriting and actuarial
department, all of which enters into the determination of the
form of policies, the rates and the risks to be assumed.
[46] Mr. Oakden in his
report described the function of head office in this area of
underwriting as follows.
▪ UNDERWRITING
- At State Farm, Headquarters is responsible for designing the
insurance product and process by which the product is sold,
underwritten and issued. The design of an insurance product is
much more than drafting the terms of the policy (in some cases
the policy wording is set in regulation). The design of the
product would include the selection of a target market,
determining a combination of coverages that would be attractive
to the target market, designing an appropriate classification
scheme, determining a pricing algorithm, establishing commission
rates, designing the applications that must be prepared by the
potential insureds and establishing the underwriting rules and
determining the price.
[47] These conclusions are
consistent with and confirmed by the evidence of Mr. John
Killian, the Vice President, Finance of State Farm and
Mr. Jeff Wickware, Superintendent of Financial Statements in
the CRO.
[48] The inevitable
conclusion that emerges is that the underwriting function as
described above is performed substantially in head office - the
design of the policies, the determination of the risks to be
assumed, the fixing of rates, the drafting of endorsements and
the development and dissemination of policies and procedures to
be followed by the regional offices and the agents in selling
policies.
[49] One may usefully
contrast the underwriting that is done at head office, in the
sense in which I use it above, with what is done at the CRO. 97%
of completed contracts submitted by agents are accepted. Coverage
is terminated in only about 2.5% of such contracts. If the
activities at the CRO can be described as underwriting at all
they are a subordinate and mechanical character. The role of the
CRO in the overall State Farm business is important. It has its
own management, claims department, underwriting department, human
resources department, data processing department, policy issue
and billing department, accounting department and it settles
investment transactions. It is obviously integral to the overall
business organization, but its role within the underwriting
function is very limited. The major underwriting function is
performed at head office. The Minister's assumption that only
one percent of the expenses allocated to CRO by head office
related to underwriting is in my view unsupported by the
evidence.
Acquisition
[50] The term
"acquisition" in the insurance industry simply means
"sales". The selling function is largely performed by
the agents. Neither the CRO nor head office deals directly with
customers nor do they sell policies. The agents obtain
information from the prospective customer, complete the
application, the form of which has been developed by head office
in the ECHO System, which determines the information required and
the rate to be quoted. The contract is issued (usually
electronically) and, subject to the possibility that the CRO may
adjust the rate up or down, or the unlikely event that CRO may
terminate the policy, the policy is complete.
[51] The front line selling
is performed by the agents, using procedures, criteria, pricing
and forms of insurance policy developed by head office. CRO's
role is largely limited to reviewing completed applications and
insurance contracts.
Claims
[52] Head office's
involvement in claims is not significant. Apart from small claims
handled by agents directly, the CRO deals with all claims,
including litigation. Rarely are claims referred to head
office.
Investment
[53] Head office makes the
investment decisions and the investment transactions are carried
out by CRO. The investments, which make up the reserves in
respect of the Canadian business, are held in Canada. State Farm
does not contest the application of the GST to the portion of the
head office expenses allocated to CRO.
[54] Before I leave the
description of the functions performed by head office I should
mention briefly the role of computer systems in the business of
State Farm. Computers are an essential tool in operation of a
business as large and complex as the one with which we are
concerned here. One of the witnesses stated that State Farm has
the largest computer network outside of the US federal
government.
[55] The computer systems
department at head office is largely involved in collecting and
analysing data which is used to determine rates, to track trends,
and to prepare pricing models developed by actuaries and
financial models.
[56] The ECHO System
analyses the data sent to it daily by the regional offices with
respect to premiums and losses. From this the ECHO System
develops policies, prices and determines what areas of insurance
the business should move into, or drop.
[57] The CRO has its own
computer system which it uses for data processing, billings and
policy mailings. The computer systems and the staff of computer
programmers gather, organize and analyse the information relating
to the Canadian business, including premiums and claims, and send
the results to head office where they are fed into the ECHO
System, digested, stored and used for the purposes described
above.
[58] The accounting rules
developed by the National Association of Insurance Commissioners
(the "NAIC") are the next aspect of this case that
warrants mention. The relevance of these rules in this case is
that all expenses incurred in the carrying on of the insurance
business are, after they have been assigned to one of the two
State Farm companies (the appellants), allocated to five major
expense groups - loss adjusting expense, acquisition,
underwriting/general, taxes and investment. Once this is done the
head office expenses are allocated to the regional offices in
accordance with a formula based upon transaction unit counts
("TUCs") or policies in force. Taxes are not allocated
to the CRO because it pays taxes to Canada separately.
[59] The above is a broad
overview of the allocation of expenses to the regional offices. A
more detailed description follows. It summarizes the statements
in Mr. Oakden's expert witness report.
[60] The genesis of the
NAIC rules was Regulation 30 issued by the State of New York
in 1948. Regulation 30 was adopted by other states and in
1950 by the NAIC whose responsibility is to develop and keep
current accounting rules relating to the expenses of insurance
companies. The purpose of these rules is to establish standard
procedures for insurance companies to follow in classifying
expenses. They require the assignment of all expenses to one of
the five categories noted above. Within each of these categories
the NAIC rules require the allocation of expenses to particular
lines of business.
[61] The expenses allocated
in accordance with the NAIC rules are reported in the Annual
Statement and the Insurance Expense Exhibit. They are used in
making income tax calculations.
[62] The reporting of
expenses of foreign insurance companies that operate in Canada
through branches is also regulated by the Government of Canada
through the Office of the Superintendent of Financial
Institutions ("OSFI"). State Farm, as a foreign
insurance company, is required to file an annual statement called
the P & C-1. P & C stands for property and casualty.
[63] The P & C-2
statement and the NAIC annual statements serve similar purposes.
The P & C-2 statements are less detailed than the NAIC
statements but the OSFI requires that expenses be grouped into
five categories which are essentially the same as the NAIC
expense categories. They are adjustment, acquisition,
insurance/general, taxes and investment.
[64] Mr. Oakden
pointed out in his report that prior to 1993 acquisition expenses
were included in the insurance/general category. After 1993 they
were split out from insurance/general and put in a separate
category.
[65] The assignment of
expenses is done by the use of a function code. The function code
does not however completely or automatically result in the
assignment of expenses to a particular category - some function
codes refer to activities that cannot readily be assigned to one
of the five categories and there is required a survey of the work
performed that underlies the particular expense before there is
an allocation to one or more of the categories.
[66] The allocation of the
expenses to the regional offices (including the CRO, except for
taxes) is based on a formula that uses TUCs, which is based upon
a physical count of new business transfers, reinstatements,
renewals and cancellations of policies in force.
[67] For State Farm Mutual
Automobile Insurance Company head office expenses are allocated
to the CRO based on TUCs. In the case of State Farm Fire &
Casualty Company loss adjustment expenses are allocated on the
basis of TUCs whereas acquisition and other underwriting expenses
are allocated based on policies in force.
[68] Before I continue with
this somewhat tedious description of the accounting practices of
State Farm, using the procedures and formulae outlined above, let
us pause to consider just what the point of all this is.
Section 220 of the ETA deems the rendering of a
service from a foreign permanent establishment to a Canadian
permanent establishment to be a supply of a service between
arm's length persons. The value of the consideration for the
supply is deemed to be the fair market value of the supply. That
consideration is deemed to have been paid by the permanent
establishment to which the service was rendered to the other at
the end of the taxation year of the recipient in which the
service was rendered.
[69] At least three
determinations are required:
(a) that a
service was rendered;
(b) what the fair
market value of the service was;
(c) whether the
service was an exempt supply.
[70] The required
ingredients of taxability were not pleaded as assumptions with
any degree of specificity. Apart from formal matters, the only
"assumptions" pleaded were that "the
Appellants' Head Office rendered Head Office or Management
Services to the Canadian Branch with respect to policies issued
to Canadians" and that "the rendered services were a
single composite supply."
[71] Paragraph 13 of
the reply in each case states
That the supply was identified and its value
determined pursuant to insurance accounting rules emphasizes that
a supply to the Canadian Branch was made.
[72] This is argument and
casts no onus on the appellants. I revert then to the question
posed above, what is the significance of the accounting
practices? Although it was not pleaded as an assumption (and
therefore no onus was cast on the appellants) one might surmise
that the Minister if he thought about it at all perceived the
accounting as establishing both that a service was rendered and
that the value of the service was commensurate with the amount
allocated by the accounting procedures. I propose to consider
whether the evidence supports this view. If it does I must then
consider whether the rendering of the service constituted an
exempt supply. If the evidence does not support the view that a
service was rendered with a fair market value equal to the amount
allocated we do not even get to section 220 of the
ETA.
[73] Tabs A-1 to A-3
of Exhibit R-1 of the respondent's book of documents are
the operating expenses statements for State Farm Mutual
Automobile Insurance Company filed with the OSFI for the years
1993 to 1997. In the 1993 statement the amount of $5,949,000 is
shown under Home Office Overhead. For 1994 the figure under this
heading is $9,546,000. For 1995 it is $13,542,000, for 1996,
$13,644,000 and for 1997 it is $20,940,000. The numbers for the
Home Office Overhead for 1991 and 1992 are $4,229,000 and
$5,426,000 respectively. For 1991, 1992, 1993 and 1994 the 7% GST
was based precisely upon the amount in the statements. I have
been unable to reconcile the figures in the statements for 1995
and 1996 with the tax assessed. However the significance of these
statements is that they appear to have formed the basis of
assessments yet the Home Office Overhead category appears not to
have been broken down among the various expense categories and I
am left with the impression that the CCRA made no analysis of the
nature of the head office expenses that were attributed to the
CRO.
[74] The appellants'
exhibits with respect to the allocation are more detailed. All
expenses attributed to Canada are initially allocated by group,
as set out in Tab 3 of Exhibit A-4, which reads
in part as follows.
Expenses are assigned to one of the following
expense groups per Regulation 30 guidelines:
Loss Adjustment Expense - (internal group
2)
All expenses related to the adjusting and
recording of policy claims.
Acquisition, Field Supervision and Collection
- (internal group 3)
All commission type expenses and other
expenses wholly or partially connected with the production of
business, collection of premiums, writing of policies, or
incurred for the purpose of assisting agents.
General - (internal group 4)
Expenses related to underwriting activities
and all expenses not assignable to other expense groups.
Taxes - (internal group 5)
All taxes, licenses and fees, except taxes on
investments and federal income taxes.
Investment - (internal group 6)
All expenses incurred in investing funds and
obtaining investment income (including expenses and taxes
relating to owned real estate).
[75] The witness John
Killian, Vice President, Finance, of State Farm, stated that
approximately 30% of head office expenses related to
underwriting, 30% to claims, 30% to sales and agency
(acquisition) and 10% to investment. I do not have the evidence
that would permit me to verify these percentages independently
and so I must take them as prima facie evidence of an
approximation made by a senior and knowledgeable officer of the
company. However, even assuming that these percentages are
roughly accurate in the overall picture of State Farm's total
business, they can not necessarily be applied to the allocation
of head office expenses of the Canadian operation. Tab 3 of
Exhibit A-6 shows a total allocation of Home Office Expenses
to Canada in 1994 of $8,386,259.70 (I assume US$) of which
$1,652,687.83 related to loss adjustment. Yet the evidence was
clear that practically nothing with respect to claims made in
Canada was done by head office. The evidence does not support the
view that the allocation to the regional offices, including
Canada, bore any necessary relationship to the work actually done
for the regional offices. It was based on TUCs or, in some cases,
policies in force.
[76] The conclusions to be
drawn from the accounting evidence are:
(a) The
allocation of the expenses to the various categories, or groups,
is based on the NAIC rules and is essentially functional. The
allocation of expenses to the categories of acquisition, claims,
underwriting and investment may, within a range of indeterminate
magnitude, be roughly accurate. There is no evidence to the
contrary and it is probable that the sophisticated procedures and
rules that have been developed by the NAIC are, given the
purposes that they are intended to fulfil, as accurate a
reflection of the function of the expenditures as one is likely
to find.
(b) Once the head
office expenses are allocated to the several categories, the
allocation to the regional offices, including the CRO, is not on
a functional basis, that is to say, the allocation is not
necessarily commensurate with the services, if any, which head
office performs for the local offices. It is based upon the
mathematical formula described above. This method, which is based
on TUCs and on policies in force may bear some rough correlation
to the value to the regional offices of what is done at head
office simply because the larger the volume of business in the
regional office the greater is likely to be the benefit to be
derived from the head office activities, particularly in such
matters as underwriting, pricing, drafting of endorsements and
statistical analysis, which are an integral part of the
underwriting function. However this is not a matter of scientific
precision so much as a matter of common sense. Presumably
whatever is done at head office should benefit the business as a
whole, wherever the business is carried on.
(c) The head office
expenses that are allocated to the CRO are not for management or
administration services. The evidence is clear that head office
provides no management or administration services to the CRO. The
CRO had its own staff and provided its own management and
administration. The function of head office insofar as it related
to the operations in Canada lay in the development of insurance
policies, pricing, determination of what types of insurance to
offer, what markets to enter or to drop, the collation and
analysis of statistical or actuarial information and the other
functions that comprise the activity of underwriting.
(d) The accounting
evidence does not establish that a service was rendered or what
the fair market value of that service was.
[77] The problem with
section 220 is that it creates a statutory fiction, or, if
you will, an artificial presumption, but it does not direct us to
pursue that presumption to its logical (or illogical) conclusion.
It leads us to the end of the diving board but provides us with
no pool into which to jump. It is possible that the inarticulate
premise of section 220 is that foreign permanent
establishments render services to Canadian permanent
establishments but this is not stated. If that is the premise it
does not matter that one may be the foreign head office and one
the Canadian branch or vice versa. Yet the premise has no
rational basis. One could as readily say that a branch office in
Canada renders services to a foreign head office. If one enjoys
philosophical conundrums, one might ask if the brain renders a
service to the hand or the hand renders a service to the brain.
The simple fact is that parts of a single organism, whether
physical or financial, whether concrete or abstract, do not
render services to each other and deeming the parts to be
separate persons, as section 220 does, does not overcome
this fundamental conceptual obstacle, even though branch
accounting practices and subsection 4(1) of the Income
Tax Act require a reasonable allocation of expenses to
sources in a particular place.
[78] My concern here
however is more mundane, and it is to determine whether the head
office expenses allocated to the CRO are subject to the GST. The
ETA says that if services are supplied by a foreign
permanent establishment to a Canadian permanent establishment the
consideration for the supply of the services is deemed to be the
fair market value of the supply of the services. The respondent
has not pleaded as assumptions or proved as facts the factual
underpinning necessary to support the assessments. This is enough
to dispose of the appeals. Even if the Crown had pleaded as
assumptions the necessary ingredients of taxability the
appellants have demolished them.
[79] Even if it could be
said that head office provided a service to the CRO that service
consisted substantially, if not entirely, in the area of
underwriting insurance policies. The assumption that "the
Appellants' Head Office rendered Head Office or Management
Services to the Canadian Branch with respect to policies issued
to Canadians" is, to the extent that it speaks of head
office services, meaningless, and to the extent that it speaks of
management services, wrong. The unpleaded assumption that only 1%
of the activities at head office related to underwriting and 5%
to claims is unsupported by and is, in fact, contrary to the
evidence.
[80] I have been unable to
see in the evidence that any management or administrative
services were rendered by head office to the CRO. If services
were rendered at all they related to a supply of financial
services as defined in subsection 123(1) of the ETA.
If any administrative or management services that cannot be
attributed to the categories of insurance contemplated by the
NAIC rules are performed by head office for the CRO they are
incidental to the financial services supplied. Accordingly
section 138 would apply.
[81] One of the few
assumptions pleaded was that the supply of services by head
office to the CRO was a composite supply. What I take this to
mean is that financial services were supplied with services that
were not financial services. If there were any non-financial
services supplied they were far less than 50% of the total and,
even if we accept the amounts allocated as evidence of the fair
market value and therefore the consideration (another unpleaded
but conjecturally implicit assumption), it will be obvious that
the consideration for the financial services is substantially in
excess of 50% and therefore section 139 of the ETA
applies. This is clear from Tab 10 of
Exhibit A-4, which deals with 1994 and 1996 but which
I take as representative of all years in issue.
[82] The respondent's
argument is that none of the services supplied by head office to
the CRO are financial services as defined by section 123 and
that they are all administrative and managerial services. The
respondent's argument would essentially restrict financial
services, in the context of the insurance business, to the
issuance of an insurance policy to an insured. With respect I
believe this interpretation is much too narrow, quite apart from
the fact that it is inconsistent with the CCRA's own
interpretation and administrative practice.
[83] I do not think,
however, that the difference between the appellants and the
respondent is on a question of law or in the interpretation of
the statute. It appears to me reasonably clear that the CCRA
accepts the interpretation of financial service advanced by the
appellants but did not, as a matter of fact, conclude that the
head office was supplying such services to the CRO. At all
events, I think the CCRA's conclusion is wrong on one of two
alternative grounds:
(a) If it
accepts the appellants' interpretation of financial services
but believes that as a factual matter the services, if any, that
were provided were not financial services as defined it is wrong
as a matter of fact.
(b) If it believes
that under no circumstances can a foreign head office ever supply
to a Canadian permanent establishment anything other than
managerial and administrative services and can never provide
financial services it is wrong as a matter of law.
[84] Counsel for the
respondent referred at some length to a decision of the Judicial
Committee of the Privy Council on appeal from the Court of Appeal
of New Zealand in Inland Revenue Comr. v. Databank Systems
Ltd., [1990] J.C.J. No. 35. Decisions of the
Privy Council and the House of Lords are not binding on Canadian
courts, but they are entitled to respect.
[85] In that case Databank
Systems Ltd. ("Databank") undertook to provide certain
services to five clearing banks. The question was whether these
services were exempt financial services under the New Zealand
Goods and Services Tax legislation, which bears some resemblance
to our legislation.
[86] The following appears
in the judgment of Lord Templeman, on behalf of the majority
(Lord Ackner dissented).
3 ...
In the course of the present proceedings a brief of evidence was
submitted by Mr. Shaw who was the manager of the bank customer
group of Databank. He explained that:
"Databank undertakes four major
activities for the Banks:
(a)
Providing a financial clearing system covering various types of
transactions (and forming part of the settlement process).
(b)
The posting of transactions to customer accounts, and maintenance
of computer files of customer accounts.
(c)
Network management.
(d)
Software support and development."
4 The
question is whether the services supplied by Databank pursuant to
the Agreement dated 17th July 1969 are financial services exempt
from the Goods and Services Tax ("G.S.T."). The
provisions of the Agreement appear to provide computer services
consistently with the first three objects of Databank set out in
its Memorandum of Association as follows:
"(a)
To provide electronic data processing facilities and services for
members of the Company and other persons;
(b)
To purchase take on lease or otherwise acquire and to install
operate and maintain machines computers apparatus equipment and
facilities of all kinds for the sorting processing calculating
collating storing and recording by electronic electrical
mechanical or photographical means or by any other means
whatsoever of accounts records data and information of every
description for all purposes;
(c)
To collect collate prepare record process and circulate
statistical information of every description and for all
purposes,
...
25
Databank carries on a business activity which involves Databank
in the supply of services to the banks for a consideration and
that activity is therefore within the scope of section 6.
Databank being involved in the requisite activity, the supply of
services by Databank is by section 8 chargeable to G.S.T. unless
the supply is an exempt supply of financial services as provided
by section 14 and defined by section 3. Exemption is not afforded
to "a person" who is "involved" in "an
activity" which "results in" the supply of
financial services; such an exemption, (which would present great
difficulties of definition and application) is nowhere to be
found in the wording of the Act. Databank is involved in the
supply of financial services by the banks to their customers;
such a supply by the banks to the customers is exempt by the
express words of the Act. Databank neither supplies services to a
customer recipient nor charges the customer. Databank is the
supplier of services which are not financial services to the
banks under and by virtue of the Agreement dated 17th July 1969
for a consideration paid by the recipient of those services.
...
28
The services by Databank enable the banks to supply financial
services to their customers for an exempt consideration. Databank
does not supply services of any kind to the customer for a
consideration. Databank supplies computer services to the banks
for a taxable consideration and there is nothing in section 60 or
elsewhere to exempt that supply from G.S.T.
29
The services supplied by Databank to the banks enable the banks
to provide financial services to their customers. Services
provided by Databank to the banks constitute the most modern and
efficient machinery yet devised for the purposes of enabling the
banks to provide financial services to their customers. Databank
supplies the machinery, in the form of computers, hardware,
software and operators. The banks make use of the machinery
supplied by Databank in order that the supply of financial
services by the banks to the customer may be efficient and
speedy. The supply of machinery is not the supply of financial
services.
[87] I do not believe this
case has any application here. To supply computer services to a
company that provides financial services to its customers does
not involve the supply of a financial service to that company. In
the State Farm case we have companies carrying on the business of
supplying financial services to customers throughout North
America. Its head office is deemed to be a separate entity from
the Canadian permanent establishment. If it renders a service to
the Canadian permanent establishment the consideration is deemed
to be the fair market value of the service.
[88] If we assume all of
the ingredients otherwise giving rise to taxability under
section 220 (none of which have been pleaded as assumptions)
we still revert to the fact that State Farm's business is the
supplying of financial services. Even if we postulate a
hypothetical supply of a service for a consideration that
hypothetical service still falls within the definition of
financial service and it is therefore exempt.
[89] In light of this
conclusion it is not necessary for me to deal with the argument
advanced by counsel for the appellants that if any services are
performed they are performed by employees of the appellants and
are therefore not services as deemed in subsection 123(1),
nor the argument that allocation of expenses by head office does
not constitute consideration for a service that is rendered by
head office to the CRO. There is considerable merit in these
points but I express no concluded view on them. The conclusions
stated above are sufficient to dispose of the appeals.
[90] The appeals are
allowed and the assessments made under section 220 of the
Excise Tax Act on the amounts of head office expenses
allocated to the Canadian Regional Office are vacated.
[91] The appellants are
entitled to one set of counsel fees at trial on the basis of one
senior counsel and one junior counsel.
Signed at Toronto, Canada, this 30th day of
January 2003.
A.C.J.
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