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Earthquake Tax Changes – August 2012

Seven New Tax Rules you need to know

By Spencer Smith and Sybrand van Schalkwyk

Before 22 February 2011, our tax rules for insurance payouts were pretty basic.

The tax rules never envisaged the complex situations that many businesses are finding themselves in with their insurers. The experience in the aftermath of Canterbury’s earthquakes quickly revealed the inadequacy of our overly simple rules. 

To give the Government credit where it is due, the IRD’s Policy Unit has moved to address the problems and to enact sensible and pragmatic rules in response to issues such as red zones and the demolition of buildings because they are uneconomic to repair.

This blog summarises 7 tax changes for Insurance Payouts that we think you should know about, including the most recent changes announced earlier this month (now included in an amendment Bill before Parliament).    

1.       Property Damage Insurance – Repairs

As we have seen, many businesses have received payouts for damage, but for many reasons they have been unwilling or unable to carry out the repairs yet.

The former rules worked fine when an insurance payout was received shortly after the repairs were made. The cost of repairs was deductible and the insurance receipt was taxable in the year the repair costs were “recovered”.  But, under the above scenario, those former rules could result in a mismatch where a business ends up paying tax on insurance receipts even if the business subsequently spends the insurance payout on repairs. 

In other situations, businesses have received interim general payouts which have not been allocated to any particular repair or claim. 

The new rules will let businesses carry forward the insurance payout and match it against the cost of repairs as they are carried out. This is a sensible and pragmatic rule. 

2.       Property Damage Insurance – Demolished Building

On demolition, an insurance payment has to be treated as if it was a receipt from the sale of the building. The building owner is liable for tax on depreciation recovered (i.e. to the extent that the insurance proceeds exceeded the written down value of the building and that excess was less than or equal to any depreciation previously claimed).

Building owners affected by the Canterbury earthquakes are allowed to elect to rollover the depreciation recovered into any replacement building that is constructed in the Canterbury region. The rollover rule will last until the end of the 2015-2016 income year (for most businesses that will be 31 March 2016).

The recent Government announcement will extend these rules to buildings that have been demolished because they were uneconomic to repair. The relief rules initially applied only to buildings that were irreparably damaged. The Government could see that the rollover relief needed to be widened as the relief did not include buildings that are uneconomic to repair as they were still arguably repairable and therefore not “irreparably damaged”. This is another sensible change.

3.       Income Replacement Insurance

Some businesses have already reached settlements with their insurers and have been compensated for past as well as future income loss.

The new rules will allow that compensation to be recognised in the income year to which it relates or the year of receipt (whichever is later).  

Under the former rules, an insurance payout of this type was essentially taxable when it is received or could reasonably be estimated. This rule could cause the income to be taxed in an earlier year, even though it was intended to relate to a later year. 

4.       Tainted Land Sold to the Government (aka Get out of Jail Free)

In some situations the sale of land will not be a capital gain.  For example, the land may be taxable because the person was associated with a dealer, developer or builder at the time they purchased the land.  In some cases the landowner can avoid tax liability simply by continuing to own the property for more than 10 years. However, in the case of a compulsory acquisition, the landowner has no control over the timing of the sale.  

As we now know, there will be some forced sales of land required under the CBD rebuild plan. The Government has announced a new rule that will be backdated to 4 September 2010. It will allow the vendor to sell on a tax free basis where there has been a forced sale.

5.       You Can Keep Claiming Expenses (even if your Business has been temporarily stopped)

Have you kept claiming your expenses, even though your business has stopped?  Well now you legally can.  But there are conditions…and watch for the special timing rule!

Currently, in the absence of a continuing income earning activity, expenditure or loss incurred is not deductible.  This rule has created a problem for people with buildings in the red zone that they are unable to rent out.  While some of the expenses for these buildings have not stopped, the Government has to make a specific rule to allow those costs to be deductible for tax purposes.

The proposed new provision only applies where an income earning activity in the greater Canterbury area is interrupted because of a Canterbury earthquake.  Also the business must recommence to get the tax deduction prior to the end of the 2016 tax year (for most taxpayers that will be 31 March 2016).  Also note – the deduction will only be allowed in the year that the business is recommenced.

6.       Keep Claiming Depreciation

A similar rule will be applied for depreciation.

Currently, for an item of property to be depreciated, the item must be used or available for use in a business.  However, where buildings are in the red zone they are no longer available for use, and technically depreciation could not be claimed. 

Although the depreciation is available to be claimed for the year in question, we understand that the depreciation loss has to be allocated to the year of business resumption, just as explained above for general expenses.

7.       Business Interruption Insurance Used to Purchase Replacement Assets

This change is the only one that might be called ‘taxpayer unfriendly’.

It affects BI insurance payments used to purchase assets under an increased cost of doing business clause in an insurance policy. Once it is enacted, businesses will have 2 choices:

(a)   Reduce the cost of the replacement assets by the amount of the insurance payment used towards those assets; or

(b)   Treat the insurance as income, spread over 10 years.

Prior to the Bill these payments would not have been taxable, and the insured person would still have been able to depreciate the new assets based on their full cost. 

There is still an opportunity for taxpayers to file under the former rules if they can file their tax return before the new rule is enacted.

Final Comment – Extension of the Rules beyond 2015-16

Some of the above tax concessions and exemptions will run out at the end of the 2015/2016 tax year.

The aftershocks have set back the timing of the rebuild. The reconstruction of Christchurch CBD cannot start until the cordon is lifted and the demolition has been completed.   

It is already apparent that many businesses will not have replaced their buildings by the time the concessions expire.  We therefore consider the exemptions should be extended for another two years at least, but that might require some lobbying.

For more about us, please follow this link: Christchurch Accountants.  Please note that this is not intended as tax advice, please take specific advice for your own circumstances.

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