Case Study on How Tax is Treated For Insurance Proceeds For Destroyed Assets
When an asset is unexpectedly destroyed, business owners usually focus on maximising insurance entitlements under their policy – and the tax treatment of the proceeds are an afterthought.
Often, insurance proceeds will result in a damaged item being replaced. Compensation may also be received to cover a loss of income. Using a case study of a warehouse destroyed by fire, this article discusses how insurance proceeds will be treated for tax. This should help business owners determine how to best apply the proceeds to their advantage.
Case Study: A Property Destroyed by Fire
Bluebird Pty Ltd (Bluebird) owns a warehouse, which is leased to Blackbird Pty Ltd (Blackbird). In January 2015, an electrical fire broke out in the warehouse causing it to burn down and fully destroy the premises. Negotiations ensued with the insurance company and it was agreed that Bluebird would receive an insurance payout of $10 million comprising of:
- $1.5 million to cover the loss of rental income; and
- $8.5 million to replace the warehouse, of which $1 million relates to depreciable assets (for the purposes of this article, let’s refer to this as “the machine”), and the balance relating to the building.
According to the tax depreciation schedule, the warehouse plant and equipment had a written down value (WDV) of $700,000 and the building had undeducted construction expenditure of $2 million (the original cost was $5 million). The building was originally constructed in 1990.
Construction to replace the warehouse is expected to be completed by 30 April 2016. The new, improved, larger warehouse is likely to require an investment of $15 million.
Loss of Rental Income
Insurance proceeds to cover the loss of rental income will be ordinary assessable income under s 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997). Therefore, Bluebird will have to recognise the $1.5 million as assessable income in the same way as it would have recognised the rental income from Blackbird.
References to insurance proceeds hereafter will be the $8.5 million payout relating to the physical assets that were destroyed.
Depreciable Assets – The Machine
Where depreciable assets are destroyed and insurance proceeds are received, there has effectively been a disposal of the assets in consideration for the receipt of the proceeds. Bluebird will be required to calculate a balancing adjustment for the disposal of the machine per s 40-285 of the ITAA 1997.
Whether the calculation results in an assessable amount or an allowable deduction will depend on whether the proceeds for the machine will exceed, or are less than, the tax WDV of the machine. Given that the tax WDV of the machine is $700,000 and $1 million was received by the Bluebird as compensation, this will give rise to an assessable balancing adjustment amount of $300,000.
Bluebird may not be required to include the assessable amount in its taxable income if it is able to apply the rollover relief under s 40-365 of the ITAA 1997. The rollover relief is available for assets that are involuntarily disposed of (that is, assets that have been destroyed or lost) where taxpayers incur expenditure on a replacement asset. This relief will allow Bluebird to rollover any assessable amount by offsetting it against the cost or opening WDV of a replacement asset.
In order for the rollover relief to apply, Bluebird must purchase the replacement asset, or start to hold it, no later than one year after the end of the financial year in which the asset was destroyed – that is, by 30 June 2016. The Commissioner has a statutory discretion to extend this deadline. The replacement asset must also be used or installed and ready for use.
For the purposes of calculating the depreciation deduction that is allowable for the new asset, the cost of the asset is reduced by the offset amount. For example, if it costs Bluebird $1.1 million to purchase a new plant and equipment, $800,000 will form the basis of the cost of the new machine when calculating depreciation. This represents the WDV of $700,000 plus the additional $100,000 spent by Bluebird. This ensures that the offset amount will not give rise to deductions.
If the insurance company had compensated Bluebird by replacing the destroyed machine with a new machine, as opposed to monetary compensation, this would give rise to a disposal of the old asset in consideration for the receipt of a new asset at its market value. For example, if the insurance company compensated Bluebird with a replacement machine that has a market value of $1 million, Bluebird could use the rollover relief, in which case the balancing charge would not arise and Bluebird would have a base for depreciation of $700,000. It is less than the $800,000 mentioned earlier because the value of the plant is less.
Capital Asset – The Building
There are two issues that are relevant when considering the tax treatment of the insurance proceeds relating to the building given that it is a capital asset – the Capital Works consequences under Div 43 and the Capital Gains Tax (CGT) consequences.
A balancing deduction under s 43-40 of the ITAA 1997 is allowable for buildings that are destroyed equal to the undeducted construction expenditure at the date of the destruction of the building, less the amount received or receivable for the destruction of the building (see s 43-250 of the ITAA 1997). The amount received or receivable includes an amount received under an insurance policy for the destruction of the capital works (see s 43-255 of the ITAA 1997).
Bluebird will not be able to claim a balancing deduction under Div 43 for the destruction of its building given that the insurance proceeds exceed the undeducted construction expenditure by $5.5 million. Taxpayers should note that for buildings constructed post–26 February 1992 and for certain buildings constructed before this date, s 43-250 will “clawback” the amount of Div 43 deduction previously claimed, or able to be claimed, by taxpayers and use it to reduce the amount of balancing deduction available.
To the extent that the insurance proceeds exceed the undeducted construction expenditure but not the cost base of the asset, there are no further tax implications. However, given that the insurance proceeds of $7.5 million relating to the building exceed the cost base of the building (ie $5 million), the capital gains tax (CGT) issues need to be considered.
Capital Gains Tax
For CGT purposes, the destruction of the building is considered to be a part disposal of an asset. This is a CGT event C1 and it should be noted that the market value substitution (modification 1) rule will not apply. The market value substitution (modification 1) rule deems market value consideration to be received on the disposal of a CGT asset: see s 116-30 of the ITAA 1997. However, the insurance proceeds relating to the building are taken to be the capital proceeds on the disposal of the building: see Taxation Ruling TR 95/35.
This means that Bluebird will derive a capital gain of $2.5 million unless it is able to apply the CGT rollover relief available for assets wholly or partly destroyed under Subdiv 124-B of the ITAA 1997. The CGT rollover relief will only be available if Bluebird is able to incur expenditure in constructing the building within 12 months after the end of the financial year in which the destruction occurred, that is, by 30 June 2016.
If the cost of the new building exceeds the insurance proceeds, then the capital gain will be disregarded under the rollover relief and applied to reduce the cost base of the new building. For example, if Bluebird receives insurance proceeds of $7.5 million and spends $9 million, its cost base after the rollover relief would be $6.5 million representing the original $5 million plus the extra investment of $1.5 million. However, if the construction of the new building only costs Bluebird $6 million yet it received $7.5 million from the insurance company to replace the building, the initial capital gain of $2.5 million will be reduced to $1.5 million under the rollover and the cost base of the new building will remain at $5 million.
Tips for Taxpayers
- Taxpayers should review whether the components of their insurance proceeds are able to provide them with the best tax outcome.
- Taxpayers should also ensure that they are within the time limits required to acquire a replacement asset so that a rollover relief is available.
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