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Christchurch earthquake: a tax perspective

Forward Focus - October 2011

Author: Greg Haddon

Recently the Government has enacted legislation to deal with the tax treatment of insured assets which were destroyed or damaged by the quakes. This has been a step in the right direction. It makes the lives of many business owners a lot easier by giving them some breathing space in a taxing time. Issues covered by the new legislation include clarifying the timing in which certain insurance proceeds should be recognised for tax purposes, easing the compliance burdens and uncertainties for many businesses. We outline these issues briefly in this article. 

Please refer to our July and September 2011 tax alerts for more details on the changes and what they mean for you and your customers.

Depreciation changes

When a customer receives insurance proceeds for irreparably damaged property that exceeds the tax book value, this results in taxable income for the customer. There have been changes in the legislation to allow this income to be deferred to a later period if the taxpayer opts for roll over relief. The income can be deferred to either the earlier of the 2016 income year, the year in which the taxpayer decides not to replace the property, or the year in which the taxpayer becomes bankrupt or goes into liquidation. This means that the taxpayer essentially has the ability to defer their taxable income relating to these insurance proceeds for up to 5 years. This deferred income is rolled over into the replacement property and when the replacement property is disposed of, this deferral may be crystallised on disposal, giving rise to taxable income at the time. It should be noted that in order to qualify for this roll over relief the replacement property must have been replaced within the greater Christchurch area.

Business insurance and loss of profits

New rules have been introduced for insurance proceeds received for the interruption or impairment of business activities. This income will be recognised for tax. It will be recognised in the earlier of the income year in which the amount is received, or the income year in which the amount is able to be reasonably estimated. Without this change the income would be derived at the time of the event giving rise to the claim, i.e. the date of the earthquake. This change enables the affected businesses to determine their income more accurately, as it would have been impossible to calculate the insurance proceeds with 100% accuracy at the time of the earthquake. Although this change addresses the ability to calculate the income, it does not necessarily look at the taxpayer’s ability to pay or meet its obligations with Inland Revenue. What would this mean for you as an insurer? For example, where a settlement has agreed upon before the end of an income year, but payment is made in the next income year, this may mean that a tax liability could arise for the insured before they actually receive the insurance proceeds. This would put pressure on their cash flow. Would you be willing to prepay an amount of their settlement, or arrange for this to be paid in instalments while the paperwork is being finalised?

A further complication arises when the claim amount is paid out in a lump sum. Often when the insured has several policies with one insurance company, this may be a solution the insurance company has come up with to reduce paperwork and other administrative issues. This can be a large amount relating to several components such as destroyed assets, damaged assets, business interruption, loss of profits or other amounts. There may or may not be a breakdown of this amount into the different categories but the tax legislation can require a different tax treatment for each of the components. So in paying a lump sum amount without providing a breakdown, the insured can be left with the difficult task of determining a reasonable basis for apportionment of the lump sum payment.

Communication is the key

As discussed in our July issue, there can be many contentious areas for insurers and the insured in the case of business interruption insurance. These areas may be best resolved through honest and open communication between the insurer and the insured. We hope that by bringing these issues to your awareness, you will be in a better position to understand your customers’ issues and help make their recovery easier. Please contact us if you want further information on any of the points above.

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