The issues surrounding the taxation of insurance receipts are not new. However, they continue to be complex. Not only is it necessary to determine whether the receipt is income or capital, it is also necessary to determine whether or not the receipt is taxable. If the receipt is taxable, it is then necessary to determine when the taxing point occurs.
Income v capital
When determining whether an insurance receipt is income or capital, the first thing to consider is what is being insured and the nature of the loss that the insurance receipt is compensating for. Where the insurance policy provides insurance against loss of income, any insurance receipts will be considered to be a replacement of that lost income and will be taxed on income account.
Examples of this type of insurance include income protection insurance, or the portion of a business continuation insurance policy relating to the loss of profits. Insurance receipts may also be treated as income where it compensates for additional costs incurred as a result of the occurrence of a specified event. For example, insurance proceeds received in relation to repairing accidental damage to an asset.
Generally, all other insurance receipts will be deemed to be capital in nature, and it will be necessary to determine if there is any capital gains tax (CGT) events associated with the receipt of the
compensation and whether any exemptions may apply.
Some insurance receipts, such as workers compensation payments or personal injury claims, may be determined based on the loss of earnings of the insured. However, they are more correctly characterised as being compensation for the loss of earning capacity, rather than the loss of actual income. Therefore, these receipts will be capital in nature.
Often insurance receipts will be made up of a combination of both income and capital items. Where possible, the receipt should be split into its various components, with the correct component of the receipt considered separately. Where it is not possible to reasonably split the receipt between its components, the entire amount will be deemed to relate to the dominant purposes of the receipt.
Taxation of insurance receipts on income account
Where an insurance receipt is received as compensation for the loss of income, the receipt is generally taxed in the same way as the income that it replaces would have been. Section 15-30 of the
Income Tax Assessment Act 1997 (Cth) (ITAA97) specifically includes insurance receipts received in return for the loss of the taxpayer’s assessable income in the year in which the compensation is
An exception to this general rule is where the insurance payment is received in the form of a lump sum in arrears. Sections 159ZR to 159ZRA of the Income Tax Assessment Act 1936 (Cth) (ITAA36)
provide that a natural person in receipt of a lump sum receipt made in arrears may be eligible for a rebate. This rebate has the effect of taxing the lump sum in the current year at the rates which would have applied had it been received in each of the years to which it relates.
In order to be eligible for this rebate, the lump sum in arrears must be equal to at least 10% of the individual’s normal taxable income (excluding the arrears) in the year in which it is received. It must also be possible to reasonably allocate the arrears to the relevant years.
The taxation of the recoupment of deductible expenses is covered by Subdiv 20-A ITAA97, and includes all types of recoupment, not just those related to insurance receipts. Section 20-30 ITAA97 contains a table which sets out the deduction provisions under which a recoupment is included in assessable income. Examples of the expenses included in this table are losses due to embezzlement, larceny or misappropriation, and expenditure deductible under the capital allowance provisions.
Where the expense is deductible in a single year, s 20-35(2) ITAA97 provides that the assessable amount will not exceed the loss or outgoing. Where the expense is deductible over two or more years, such as the acquisition of a depreciable asset, or expenditure incurred over several years, the methodology contained in s 20-40 ITAA97 is used to determine the amount to be included in the taxpayer’s assessable income in the year of receipt.
Where a recoupment may be captured by both Subdiv 20-A and the balancing adjustment rules under Subdiv 40-D ITAA97, s 20-45 ITAA97 provides that the amount which may be assessed under
Subdiv 20-A will be reduced by any assessable balancing adjustment.
Section 20-50 ITAA97 provides that where the expense is only partially deductible, the assessable recoupment is limited to the deductible proportion of the expense.
Taxation of insurance receipts on capital account
The ATO has issued TR 95/35 which sets out the Commissioner’s views in relation to the application of CGT to compensation payments received, including insurance receipts. While this ruling was issued prior to the introduction of the ITAA97 and repeal of most of the relevant provisions of the ITAA36, the transition of the operative provisions from the ITAA36 to the ITAA97 means that the interpretation of the sections mentioned in the ruling is still relevant.
This ruling categorises compensation receipts, including insurance receipts, into the following four types of compensation:
- received on the actual disposal of the underlying asset (or part of the underlying asset);
- received due to the permanent damage to, or permanent reduction in the value of, the underlying asset, without actual disposal;
- received on the disposal of the right to seek compensation, without the actual disposal of the underlying asset; and
- received as a result of an act, transaction or event not covered by any of the above.
Compensation received on the actual disposal of the underlying asset
From an insurance perspective, compensation received on the disposal of the underlying asset usually takes the form of a receipt in relation to the destruction or loss of the asset. This disposal of
an asset will result in a CGT event occurring in relation to that asset, with the compensation receipt being included in the consideration for the event.
When determining the taxable capital gain or loss realised on the disposal of the asset, the normal CGT rules will apply. This will include the application of the 50% discount where the asset had been held for greater than 12 months, and the small business CGT concessions, where applicable. The normal exemptions to CGT will also apply, such as for a main residence, personal use assets costing less than $10,000, pre-CGT assets, motor vehicles or depreciating assets.
Where the insurance proceeds are used to purchase a replacement asset, or the insurer provides a replacement asset, the taxpayer may elect to apply the replacement asset roll-over contained in
Subdiv 124-B ITAA97. Under this roll-over, the replacement asset will be deemed to take on the original cost base and purchase date of the original asset. This will include the retaining of the pre-CGT status where the original asset was acquired prior to 20 September 1985.
Subdivision 124-B applies to a range of compensation receipts, not just insurance proceeds. Some of the events giving rise to some of these receipts may be anticipated in advance. Therefore, the roll-over may be applied to a replacement asset acquired prior to the disposal of the original. If the taxpayer receives money as compensation for the disposal of the asset, at least some of the expenditure in acquiring a replacement must be incurred within the two-year period starting one year prior to the event, and ending one year after the event, or such further time allowed by the Commissioner in special circumstances. As insurance proceeds are usually received in relation to unexpected events, the relevant period to incur the expenditure will generally be the year commencing from the date of the event.
It should be noted that it is only necessary to incur some expenditure in relation to acquiring the replacement asset within this period, rather than actually acquiring the replacement asset. This will be relevant where the original asset is a building which is destroyed, and a replacement building constructed with the insurance proceeds. In this situation, it is not necessary for the replacement building to be completed within a year, provided that at least some expenditure relating to the replacement building has been incurred.
Where the insurance receipt exceeds the cost of the replacement asset, the excess amount that will result in the realisation of a taxable capital gain. Where the original asset is not subject to CGT, for example, a main residence or pre-CGT asset, this realised capital gain will also not be taxable.
In order to be eligible for the roll-over under Subdiv 124-B, it is also necessary for the replacement asset to be used for the same or similar purpose as the original asset for a reasonable time after its acquisition.
While the disposal of a depreciable asset will not result in the realisation of a taxable capital gain or loss, it will still be subject to the balancing adjustment rules within the capital allowance provisions of Div 40 ITAA97. The insurance receipt will be treated as proceeds received on the disposal of the asset for the purpose of calculating the balancing adjustment.
Section 40-365 ITAA97 provides a replacement asset roll-over where a replacement asset is acquired following the involuntary disposal of the original depreciable asset. Where a taxpayer elects
to apply this roll-over, the replacement asset will be treated as a continuation of the original asset, with the capital allowance (depreciation) deduction calculated based on the original asset’s cost and effective life.
In order to apply this roll-over, the taxpayer must either incur the expenditure in relation to acquiring the replacement asset, or start to hold it for capital allowance purposes, within the period commencing one year prior to the event, and ending one year after the event, or such further time allowed by the Commissioner in special circumstances.
Compensation received due to the permanent damage to the underlying asset
Where there is no disposal of an asset, but that asset is permanently damaged, or there is a permanent reduction in its value, any compensation payment received will reduce that asset’s cost base. This compensation is treated as a recoupment of the costs incurred in acquiring the asset, and are excluded from the asset’s cost base according to s 110-45(3) ITAA97. CGT event H2 may occur where an act, transaction or event occurs in relation to a CGT asset, and this event does not result in an adjustment to the asset’s cost base. As TR 95/35 treats these receipts as a recoupment of expenses reducing the asset’s cost base, there is no CGT event which occurs, and therefore no taxable capital gain where the receipt exceeds the asset’s cost base.
Compensation received on the disposal of the right to seek compensation
Paragraphs 183 to 187 of TR 95/35 discuss the compensation received under an insurance policy as being received on the disposal of the right to seek compensation. The specific example in these paragraphs deals with an insurance policy against liabilities arising out of negligence. For CGT purposes, the right to compensation under the insurance policy will be deemed to be acquired at the time that event giving rise to the negligence claim occurred. The cost base will include the amount which the insured is required to pay to the claimant, together with any other costs related to the claim.
As the insurer will generally only cover the amount payable to the claimant, the proceeds will generally be equal to the cost base, and there will be no taxable capital gain or loss.
Where the insured party is required to pay an excess, or other uninsured amount, to the claimant, this amount will result in the realisation of a capital loss, as the cost base (the amount owed to the claimant) will be less than the proceeds (the amount paid by the insurer).
Compensation received in relation to any other act, transaction or event
TR 95/35 does not provide any detail on the treatment of receipts which do not fall within the other three types of compensation. Therefore, it is necessary to consider general principles when determining the taxation treatment of such a receipt.
Taxation of personal injury or life insurance receipts Section 118-300 ITAA97 provides an exemption from the CGT rules for insurance proceeds received in relation to an insurance receipt resulting from either a life insurance policy, or a sickness or injury policy. This would be consistent with the principle that an individual’s life and health are not in themselves CGT assets, and are not used in producing assessable income.
Any receipts from an income protection portion of a personal injury or life insurance policy will be taxed as income as discussed above.
When determining the correct taxation treatment of any insurance compensation received, it is essential to review both the insurance policy and any documents which accompany the receipt. This will allow the taxpayer to correctly identify the nature of the compensation, as well as split the receipt into the correct components where the compensation relates to two or more different types of loss.