Navigating Insurance Proceeds and Tax
When the unexpected occurs—such as a fire, flood, the passing of a family member, or major equipment failure—insurance proceeds can offer much-needed relief. Here are some quick tips: ensure your personal and business insurance policies are kept up to date and reviewed annually. Additionally, with the growing importance of cybersecurity, consider the risks of being scammed or having client data stolen.
From a tax perspective, however, the treatment of insurance payments isn’t always straightforward. While many businesses instinctively classify insurance proceeds as taxable income, this isn't always necessary. Applying the correct tax treatment can potentially reduce your tax liability.
If the insurance proceeds relate to a depreciable asset that’s been lost or destroyed, the key comparison is between the proceeds and the asset’s adjusted tax value (ATV). The ATV of an asset is calculated by subtracting any depreciation claimed from the asset’s original purchase price. It reflects the remaining value of an asset for tax purposes, which may differ from its market value.
To determine the appropriate tax treatment, you should consider the following high-level guidelines:
- If the proceeds exceed the ATV but are less than the original cost, the difference should be treated as taxable income.
- If the proceeds exceed both the ATV and the original cost, only the amount up to the original cost is taxable income. The additional amount should be treated as a capital gain for tax purposes.
- If the proceeds are less than the ATV, the difference should be treated as a loss on disposal.
For damaged assets, where the insurer covers repairs, the proceeds should not be taxable, and no deduction is allowed for the repairs. However, if the proceeds received exceed the actual repair costs, the excess reduces the asset’s ATV. If this reduction results in a negative ATV, that negative amount becomes taxable income, to the extent of depreciation claimed.
Another aspect to consider is the GST impact. Ordinarily, insurance payments made to GST registered businesses or individuals are made on a GST inclusive basis. Therefore, the insurance proceeds should be included in the GST return for the period they are received. Conversely, when the replacement assets are purchased, the GST on these costs should be claimed back.
As we know from natural disasters and significant events across New Zealand in the last few decades, the insurance process can stretch over a number of years. Consideration should be given to whether Inland Revenue has made any specific concessions (as observed with the Canterbury Earthquakes and Cyclone Gabrielle), timing of asset disposals, allocation of insurance proceeds and treatment of split payments.
Remember, not all insurance proceeds are taxable. Assess what the payment was for and how it aligns with the ATV to ensure the correct tax treatment.