22/06/2015
Even disasters have tax consequences: the implications of insurance receipts
KEY POINTS
• Insurance proceeds may include both income and capital elements.
• Compensation for loss of income, stock and repairs will be taxed as income.
• Generally accepted accounting practice principles will apply, so tax may be payable before receipt.
• Adjustments to capital allowances or capital gains tax computations may be required.
• Business records may need to be recreated to enable the correct tax treatment to be ascertained.
Businesses that are unlucky enough to suffer an event such as a fire, flood or an infestation face many problems. The disruption to the trade or business caused by lost or damaged business records and the need to repair premises and replace other assets cannot be underestimated.
While adequate insurance cover may soften the blow, the insurance monies received will need to be recognised in the accounts and will have tax consequences. In this article we provide practitioners with an overview of the tax rules on insurance recoveries for a business based on our experience of applying the rules in real life.
Insurance proceeds may include both revenue and capital receipts with the actual tax consequences depending on the nature of the insured loss and, in some cases, how and when the insurance monies received are used.
It is important for tax advisers to discuss the insurance claim with their client to ascertain the constituent parts of the insurance receipts well in advance of tax payment dates.
Practical problems will invariably be encountered when trying to establish the correct tax outcome, especially where key business records have been damaged or completely destroyed. The client’s insurance claim form and subsequent correspondence with the insurance company is often a useful source of information.
Circumstances
Insurance proceeds that are normally treated as revenue can include, for example:
• compensation for loss of profits;
• compensation for lost or damaged stock; and
• reimbursement of trading expenses such as repair and redecoration costs, the costs of removal or storage, or the use of temporary facilities.
The treatment of recoveries for loss of profits as trading receipts has been tested in the courts several times. The most cited is London & Thames Haven Oil Wharves Ltd v Attwooll 43 TC 491, where compensation representing the loss of profits resulting from being deprived of the use of a damaged jetty was held to be part of the company’s trading receipts.
The underlying principle established in this case, and reiterated in subsequent cases, is “that compensation for loss of a benefit which, if it had matured, would have been taxable, is itself taxable.”
HMRC’s Business Income Manual at BIM40751 further states that recoveries to compensate a trader for a hole in profits are treated as trading receipts even if the amount received exceeds that hole.
This principle was established in Green v J Gliksten & Son Ltd 14 TC 364, where the replacement value of the company’s stock of timber was held to be part of its trading income. This was even though most of the stock was not replaced and the replacement value of the stock was significantly in excess of the accounts carrying value.
Insurance proceeds received in respect of the costs of a deep clean and new coat of paint for trading premises that have suffered smoke damage would be treated as a trading receipt
if a deduction was or could have been claimed for the costs.
This treatment would also apply to insurance proceeds in respect of removal costs, temporary office or storage costs that have been incurred etc.
In addition to existing case law, which dictates the circumstances in which recoveries are treated as trading income, CTA 2009, s 103 and s 210 specifically provide that receipts of a non-revenue nature, for the reimbursement of expenses which have been treated as deductible in computing the profits of a trade or property business respectively, should be brought into account as trade or property business receipts up to the amount of the deduction.
Timing
Making successful insurance claims can be a slow process and, in the writers’ experience, recoveries may be received many months, or even years, after the events giving rise to the claim.
Once it has been established that revenue treatment applies to a particular insurance receipt, the next step should be to consider the timing of recognition of the receipts for tax purposes and then to ensure the client is aware of when the related tax liabilities will fall due for payment.
HMRC’s Business Income Manual at BIM40751 helpfully states: “The time at which recoveries should be included in trading income will be based on the principles of generally accepted accounting practice.”
Therefore, where a client’s accounts have been prepared in accordance with UK GAAP, recoveries should fall to be taxed in the period in which they are recognised in the accounts.
Under UK GAAP, receipts will generally be recognised in the same period that the related loss or expense is incurred, unless the receipt cannot be reasonably quantified by the end of that period.
It is interesting to note that, in a case that is regularly quoted, Rownson, Drew and Clydesdale Ltd v CIR [1931] 16 TC 595, proceeds received in the accounting period after the period of the loss fell to be treated as trading receipts of the period of the loss and not the period of receipt.
This was because it was ruled that the receipt was ascertainable at the end of the earlier period. This case was decided more than 80 years ago and the ascertainable requirement has now been incorporated in UK GAAP.
Practitioners should therefore take into account the principles of UK GAAP when advising clients and ensure that receipts are taxed in the correct accounting period.
The potential taxation of income before it is received can present cash flow problems for businesses. This may be particularly relevant for companies in the instalment payment regime that may need to factor insurance receipts into account when calculating quarterly tax payments. Advising clients of potential tax liabilities well in advance of any due dates can help them manage their cash flow.
If a client cannot afford to pay the tax until the insurance proceeds are received, we recommend calling HMRC’s business support helpline service to try to agree that the tax will not be paid until the insurance money is received.
Capital allowances
Where insurance proceeds are received in respect of an asset on which capital allowances have previously been claimed, a disposal value is required to be brought into account for capital allowances purposes if:
• the asset ceases to be owned;
• possession of the asset is lost in circumstances where it is reasonable to assume that the loss is permanent;
• the asset ceases to exist as such (as a result of destruction, dismantling or otherwise); or
• the qualifying activity is permanently discontinued.
Should the above not apply, there is no capital allowance disposal event and the receipt of insurance proceeds in respect of the asset is likely to be a revenue or chargeable gains receipt, depending on whether the insurance monies are used to meet a revenue cost or expense.
If any of the above disposal events occur, for example if qualifying assets are stolen or destroyed, a disposal value is required to be brought into account in the relevant capital allowance pool.
The disposal value would be the amount of the proceeds limited to the original cost of the asset in the normal way and could include insurance proceeds, other compensation received, plus any sale proceeds received from the sale of the remains of the asset.
Some assets may require dismantling or demolishing before they can be removed. The net demolition costs are treated as part of the cost of any new plant that is needed.
If the plant is not replaced then the costs are added to qualifying expenditure for capital allowances purposes for the chargeable period in which the demolition takes place. Net demolition costs for this purpose are the costs of demolition less any insurance receipts and any other monies received for the remains of the asset.
Practitioners should note that CAA 2001, s 61 requires that the disposal value is recognised in the period in which the disposal event takes place, regardless of when the related insurance monies or other compensation is received.
Where there are delays in settling claims it may be necessary to file tax returns on the basis of best estimates and amend these later, after the actual disposal values are known.
Chargeable gains
In addition to a sale, disposals for chargeable gains include circumstances where capital sums are “derived from assets”. This includes, in particular, the receipt of compensation or insurance proceeds for any kind of damage, destruction or loss of a chargeable asset.
Heather Miller’s article Pizzicato’d discussed the capital gains tax liabilities arising where a valuable chargeable asset had been lost or damaged and insurance proceeds were then received.
Several scenarios were explained including where the insurance or other compensation monies were used to restore the damaged asset, or to replace the asset that had been lost or destroyed.
We will not revisit the examples in this article but, as a reminder, the chargeable gains treatment will depend on a number of factors, including:
• whether there has been a complete loss of the asset;
• whether a capital sum is received in respect of the
• asset; and
• whether the capital sum is applied wholly or partly in replacing or repairing the asset.
The same chargeable gains rules set out in Heather’s article apply equally to assets used in a qualifying trade or property business.
However, note that the trade and business assets which may be the subject of the insurance claim will very likely include wasting assets. By definition, items of plant and machinery that qualify for capital allowances are deemed to be wasting assets with a life of less than 50 years.
If the insured asset is a passenger vehicle within TCGA 1992, s 263 or a chattel (tangible moveable assets), which is a wasting asset for which no capital allowances claim has been made, then any gain arising will be exempt.
The full chattels exemption will not be available if capital allowances have been claimed but the limited chattel exemption in TCGA 1992, s 262 could apply separately to each asset to exempt some or all of the gains from the charge to tax.
Practitioners should remember that any capital loss arising would be restricted to the extent tax relief has already been given in respect of an asset by way of capital allowances.
In addition to the special rules that apply where insurance proceeds or compensation are received, the usual capital gains rules and reliefs continue to apply including, in particular, the potential to roll over gains on qualifying trade assets if the relieving provisions in TCGA 1992, s 23, as described in Heather’s article, are not available.
Lost or damaged records
Regardless of whether insurance proceeds are received for capital or for revenue losses, the key to establishing the correct tax treatment normally relies on the client having good historical records. Unfortunately, in many insurance recovery cases, these records have either been completely or partly destroyed, so key information is often missing.
Where information is lost or damaged, HMRC requires taxpayers to do their best to recreate the missing records. If this is not possible, taxpayers are required to inform HMRC of this as soon as possible.
In these circumstances HMRC should normally agree that tax returns can either be prepared on the basis of estimated figures, where actual figures cannot be provided, or on provisional figures, where there are delays in recreating the true figures.
In either case it is likely that a fair amount of judgment will be required and practitioners will need to consider with their client suitable disclosures to include in the tax return.
Summary
While tax consequences are probably the last thing on a client’s mind after a major incident, such as a fire or a flood, they cannot be ignored. Practitioners should be on hand to advise their clients on potential liabilities and payment dates as soon as possible, especially because establishing the correct tax treatment may involve the laborious task of recreating missing records.
