Important tax relief for property-owners who have sustained property damage in the Canterbury earthquakes is available through legislation passed last week.
This Brief Counsel explains the relevant provisions in the Taxation (Tax Administration and Remedial Matters) Act 2011. For specific advice, please contact Chapman Tripp.
Forms of relief
|Depreciable assets||Insurance payouts (and other compensation) for depreciable assets will not be taxable if they exceed the asset's depreciated book value, to the extent the taxpayer uses the payouts to replace the asset|
|Revenue account buildings||Insurance payouts and compensation for buildings held on revenue account will not be taxable if the buildings have increased in value as long as the payout is used to replace the building.|
|Insurance receipts||Insurance received for loss of profits due to the interruption and impairment of business does not have to be recognised until the earlier of when the insurance amount is able to be estimated or is paid (rather than in the year the loss occurred). This applies to all taxpayers, not just those impacted by the Canterbury earthquakes, and does not require any action by taxpayers to activate.|
Relief for destroyed depreciable assets
When a depreciable asset is disposed of, the proceeds are taxable to the extent they exceed the tax depreciated value of the asset, up to the original cost of the asset. This is called “depreciation recovery income”. This treatment also applies to insurance proceeds for a depreciable asset that is lost or destroyed. Under the new rules (section EZ 23B of the Income Tax Act 2007), a taxpayer’s depreciable assets are grouped into classes:
- pool-method property, and
- other property.
Taxpayers calculate their net depreciation recovery income for each class of asset. If a taxpayer has depreciation recovery income for a class, he or she can “suspend” this income (i.e. defer its recognition) if he or she intends to replace the damaged assets.
The taxpayer must notify the Commissioner in writing that he or she elects into this treatment by 31 January 2012, or, if it falls after that, in the tax year the insurance payout is calculated. Written notice must also be given in each subsequent year the income is suspended.
If a replacement asset is purchased or built before 31 March 2016, a portion of the asset’s cost is removed from the suspended recovery income and is also taken off the cost base for depreciation of the asset.
The effect of this is to roll over the depreciation claimed on the destroyed asset into the cost base of the new asset. If the asset is a building, the replacement building has to be in greater Christchurch (that is, Christchurch City, Selwyn District, and Waimakariri District).
If there are multiple assets in a single class that are destroyed, the relief is limited to the cost of the destroyed assets. The depreciation recovery income is allocated to assets purchased each year on a “first-in, first out” basis until the suspended recovery income is exhausted. Assets will then be depreciated normally.
Taxpayers may be able to manage the order in which they acquire replacement assets so as to reduce the cost base of the replacement assets with lower depreciation rates.
Expenses incurred in construction before 31 March 2016 count towards this treatment, but expenses incurred afterward will not. We recommend taxpayers seek specific tax advice if they are concerned that significant rebuilding expenditure may be incurred after that date.
Any outstanding amount of suspended recovery income on 31 March 2016 will become income of the person on that date. It will also become income of the taxpayer if the taxpayer decides not to replace the asset or becomes insolvent.
A taxpayer buys a building for $1,000,000 in 1996, and its depreciated tax book value by 2011 is $700,000. The building is destroyed following the earthquakes and the taxpayer receives an insurance payout of $1,100,000. Normally the taxpayer would have depreciation recovery income of $300,000, being the difference between the cost of the building and its depreciated value, and a non-taxable receipt of $100,000.
If the taxpayer elects into the new regime, and builds or purchases a replacement building for $1,100,000, the $300,000 will not be depreciation recovery income for the taxpayer. In addition, the cost of the building, for depreciation purposes, will be reduced by $300,000 to $800,000. The net effect of this treatment is to roll over the depreciation already claimed into the replacement asset and defer recognition of any depreciation recovery income until that asset is sold.
Relief for destroyed revenue-account buildings
A very similar treatment applies to buildings that are held on revenue account. Most businesses will not hold their buildings on revenue account unless they are property developers or speculators.
An insurance payout, to the extent it exceeds the building’s purchase price, would usually be completely taxable. The new regime allows a taxpayer to suspend this income (by giving written notice to the Commissioner as above) where the taxpayer intends to use the insurance proceeds to acquire a replacement building. When calculating any profit or loss on the sale of the replacement building, its cost will be reduced by the amount of suspended recovery income.
The effect of this is to defer the tax recognition of this insurance payout until the sale (or destruction) of the replacement building.
Any unused suspended recovery income will be income if the taxpayer no longer intends to replace the property, or becomes bankrupt or insolvent. It will also become income on 31 March 2016, which may pose problems for those who intend to replace by reconstructing. We recommend taxpayers seek advice on how to structure their transactions to ensure they get the benefit of this relief.
Change in timing for business impairment compensation
Before the amended legislation, insurance payouts had to be “matched” to the loss that was incurred — that is,the income had to be recognised in the same income year as the loss.1
The amending Act changes this for insurance or compensation received for the loss of profits due to business interruption or impairment. The new rule is that these payouts are taxable when they are received, or when they are able to be estimated, whichever is earlier.
This treatment only applies to the extent the compensation is for loss of profits and applies to all taxpayers, not just those in Canterbury, for amounts received after 4 September 2010.
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