Earthquake issues continue to shake up the tax rules
It’s been over two years since the first big Christchurch earthquake. From the time of that earthquake and through all the subsequent shakes, tax issues have continued to emerge due to the varied circumstances businesses have found themselves in after the shakes.
The Government and officials have been working hard to ensure that tax legislation continues to support businesses and people in Christchurch who are faced with the unique challenges a major disaster presents. A number of changes have been made to tax legislation since September 2010, with the most recent changes being included in the recently enacted Taxation (Annual Rates, Returns Filing, and Remedial Matters) Act 2012.
So what relief does this new legislation bring? In summary it brings the following:
- Better matching of expenses and income;
- Land and buildings purchased by the government are deemed to be owned on capital account and not taxable;
- Deductions can now be claimed where taxable activity is resumed, if it has been interrupted by the Canterbury earthquakes;
- Extension of the roll-over relief provisions to include property deemed uneconomic to repair;
- Additional measures to cope with damage to property and assets, including deemed sale and purchases and optional timing rules;
- Amendments to consideration on disposal of assets, thin capitalisation rules and the definition of capital contribution.
We comment in more detail on some of these changes and the issues arising.
Business interruption insurance
Previously, business interruption insurance was included as income when you were able to reasonably estimate the amount you would receive. This meant that if you could reasonably estimate your business interruption insurance in 2011 for the 2012 year, then you would have to pay the tax on it in 2011. The latest changes now prevent the ‘early’ allocation of business interruption insurance by allowing you to defer the income to at least the year to which the payments relate. This rule applies generally from the 2012 income year, or from the 2011 income year for those with an extension of time for filing a tax return if they have been affected by the Canterbury earthquakes.
Asset repairs and insurance receipts
Many Christchurch businesses have received insurance payments for damage but have not yet completed repairs, or finalised repairs. Previously the tax treatment of insurance proceeds was difficult. Insurance proceeds were income to the extent of repairs claimed as a deduction with any surplus reducing the tax book value of the insured asset. If the tax book value became negative the negative amount was treated as taxable income. In the current climate many businesses are finding a mismatch in timing, as the insurance proceeds are often received and then the repairs are not done until the following tax year and in some cases potentially even spanning a number of tax years.
Now under the new tax rules you can defer any income from insurance proceeds to the later of when the expenses for the repairs are actually incurred, or when the insurance proceeds are received. There is also a special additional timing rule where insurance proceeds and repair costs can be allocated to the earlier of the 2016 income year, or the year the insurance proceeds are received and the repair costs have been incurred. If this additional timing rule is applied, it must be used for all items of depreciable property damaged by Canterbury earthquakes.
Where the insurance proceeds exceed the cost of the repairs, the excess needs to be deducted from the tax book value of the asset. Any remaining excess is income and taxable to the extent that the remaining excess does not exceed the amount of the tax depreciation previously claimed on the asset. For example:
A business receives an insurance payment of $1,000,000 to repair an asset. The repairs cost $800,000. The cost of the asset was $250,000 and the tax book value before the earthquake was $150,000.
Cost of repairs
Less insurance payment
Difference between repair and insurance payment
Less tax book value
Income to include in tax return
If the cost of the asset had been $180,000 (with a tax book value of $150,000) only $30,000 of the excess would be taxable. In both scenarios the resulting adjusted tax book value for the asset will be nil going forward.
If you have any damaged property that is depreciated in a pool, the adjusted tax value of the pool is reduced by the amount that the insurance proceeds received exceed the expenditure or loss incurred. For example, a business receives an insurance payment of $5,500 to replace some of their office furniture which is depreciated in a pool. The replacement furniture only costs $4,500, which leaves an excess of $1,000. The business must reduce the adjusted tax value by $1,000.
Land and buildings on revenue account
There was initially some concern that purchases of land and buildings by the government would be taxable in certain situations. For example, the land is taxable because the person was, or was associated with, a dealer, developer or builder at the time they acquired the land, if there has been non-minor development of the land within 10 years of its acquisition. In some instances the landowner would try and hold this type of land for more than 10 years to ensure that they were not taxable on the sale.
The Government has introduced a new rule which ensures that anyone who has held land for less than 10 years and has that land purchased by the Government because of the Canterbury earthquakes will not be taxable. Essentially they are deemed to hold the land on capital account. This will also cover those that are forced to sell their land under the CBD rebuild plan. Note that this rule does not apply to land initially purchased with the intention of resale and development. This rule also has a retrospective effect and has been backdated to 4 September 2010, so there is room to request amended assessments for returns which have been filed under the old rule.
Additionally, relief may be available if you have any land or buildings held on revenue account that are demolished and income would otherwise arise because the insurance proceeds received exceed the cost of the building. Under the rollover relief provisions, you are not taxed immediately on any insurance or compensation which would ordinarily be income if you purchase replacement property before the 2016 income year as the expenditure on that replacement purchase is taken into account.
These rules seem favourable to those dealers and developers who hold land on revenue account, but raise a number of questions such as are you deemed to have bought the replacement land at the same time as the original purchase? Or are you back to square one with the clock reset on the 10 year period for your replacement holding? Based on the way the depreciation rollover relief measures operate and the fact the rules are concessionary, the replacement land should be deemed to be purchased at the same time as the original purchase. Officials have indicated that subsequent land purchases may have the clock reset on the 10 year period; however, we await further guidance as to how this may operate.
Relief where property is uneconomic to repair
The tax depreciation roll-over rules which were introduced last year have been extended to include depreciable property that is assessed as uneconomic to repair. The roll-over rules essentially roll forward depreciation recovered (which would ordinarily be returned as income) into the tax value of a replacement asset, provided certain requirements are met. This measure provides cash flow relief upfront by deferring tax payable on the depreciation recovery income in the year of the “deemed sale”. Depreciation recovery income, if any, becomes taxable when the replacement asset is eventually sold.
If you have depreciable property that is not irreparably damaged but assessed as uneconomic to repair and you receive an amount of insurance for the damage, for tax purposes you are treated as disposing of the item for an amount equal to the insurance proceeds and then repurchasing the item for zero consideration. On this basis Inland Revenue has stated that any repairs after the deemed disposal are in fact capital and non-deductible, as the asset has been (deemed) purchased in a dilapidated state and the repairs bring the asset back to a functional state.
If you have property that is assessed as uneconomic to repair (in which case there is a deemed disposal and reacquisition) the land provisions will not treat this as a disposal or reacquisition.
Where income-earning activity is interrupted or access to property is restricted
Many Christchurch businesses have been closed for a period due to damage sustained in the earthquake and under the ordinary principles they have been unable to claim deductions for expenses, as it is necessary to be carrying on a business or deriving income. New concessions have been introduced which allow the deductions in the year that business operations are resumed, provided this is prior to the 2017 income year. This rule will allow those situated in the red zone, or with buildings that have restricted access, to deduct any expenses in the year operations resume. There are still some questions to be answered in this area. For instance, are you still carrying on a business and able to deduct expenses if you are receiving business interruption insurance? Logic says that you should be able to continue deducting expenses as you are still deriving income and paying tax on that income.
A further issue arises where access to depreciable property is restricted, as property must be used or available to use in the income year in order to continue depreciating the property. The government has introduced a concession which allows you to depreciate the property where access is restricted due to the effects of an earthquake, providing the property is once again accessible by the 2016 income year. It appears this is not just applicable to property restricted by the red zone boundaries but to any property where access is restricted.
Miscellaneous matters – disposal costs, thin capitalisation and capital contributions
When there is a disposal due to irreparable damage (or a building is rendered useless), the amount derived as consideration for the disposal now includes the net proceeds on disposal, i.e. the scrap value. Originally consideration included just the insurance proceeds and not any disposal proceeds.
Where assets are impaired due to damage from an earthquake, you now have the option of including the insurance proceeds as an asset in your thin capitalisation calculation, to the extent of any impairment to the underlying asset, until the insurance is recognised as income. This effectively neutralises the impairment for thin capitalisation purposes.
The definition of capital contributions has been updated to include insurance payments for interruption or impairment of business that are used to purchase replacement property. Effectively this will mean either the cost base for depreciating the asset is reduced, or the insurance proceeds are treated as taxable and spread over 10 years.
The changes have addressed a number of issues that Christchurch businesses have been facing. Fortunately we’ve been lucky enough to have a Government and officials who are willing to listen to tax problems and consider solutions. Long may it continue as the situation continues to grow and develop with unique and complex scenarios arising and no doubt further queries will arise.
If you have any queries on Christchurch Earthquake related matters please contact us.
Tax Alert December 2012 Contents
- Tax Alert - December 2012
- Allowances: balanced issues paper proposals blighted by accommodation bombshell
- Hope for best, prepare for the audit
- Changes loom for mining taxation
- Payments to Non-Resident Film Renters – did you know the rules have changed?
- Attributable FIF income method – election may be required!
- Changes made to record keeping allowances
- Taxing multinational companies
- Australian Government releases Exposure Draft of new transfer pricing legislation for Australia